G
reenwichRoundtable
The Education Committee of
The
Knowledge, Veracity, Fellowship
2009
In This Issue
Building a Successful
Portfolio of Alternatives
The Two Principles
Putting It All Together:
The Old School &
The New School
Good Governance: The
Crucial Element
Best Practices In
Alternative Investing:
PORTFOLIO CONSTRUCTION
Research
Council
Anonymous
BlackRock, Inc.
Blenheim Capital Management
Bridgewater Associates, Inc.
Graham Capital Management
Lumina Foundation
Kingdon Capital Management
Marlu Foundation
Newman’s Own Foundation
Paulson & Co., Inc.
Price Waterhouse Coopers
About the Greenwich
Roundtable
Education
Committee
T
BEST PRACTICE MEMBERS
he Greenwich Roundtable, Inc. is a not-for
profit research and educational organization
located in Greenwich, Connecticut, for
investors who allocate capital to alternative
investments. It is operated in the spirit of an
intellectual cooperative for the alternative
investment community. Mostly, its 200 members
are institutional and private investors, who
collectively control $6.9 trillion in assets.
The purpose of the Greenwich Roundtable is
to discuss and provide current, cutting-edge
information on non-traditional investing. Our
mission is to reveal the essence of both trusted
and new investing styles and to create a code
of best practices for the alternative investment
industry.
Edgar W. Barksdale
Federal Street Partners
Chairman
Nathan Fischer
Lumina Foundation for Education
Ray Gustin IV
Drake Capital Advisors, LLC
Robert Hunkeler
International Paper Company
Lyn Hutton
Commonfund Group
Russell L. Olson
Formerly Eastman Kodak pension fund
Alexis Palmer
Memorial Sloan-Kettering Cancer Center
The Research Council enables the
Greenwich Roundtable to host the
broadest range of investigation that
serves the interests of the limited
partners and investors. This group
wishes to help investors document
the allocation process. Their business
activities serve as an example to all
of their sincere desire to educate
investors and of their belief in our
mission. Members of the Research
Council not only provide no-strings
funding but they have also assisted
the members of our Education
Committee by rolling up their sleeves
in the discovery and editing phases.
Alexander Poletsky
Greenwich Roundtable, Inc.
Editor
Mark Silverstein
Endurance Specialty Holdings Ltd.
Aleksander F. Weiler
CPP Investment Board
Leader, Best Practices Subcommittee
The Education Committee has been working as a
group of altruistic investors who contributed their time
and worked to raise professional standards. The final
result is intended to demystify alternative investing
and to bring about greater understanding. Investing
in alternatives is not well documented. The Education
Committee is chartered to conduct original research
and develop best practices from the investors’ point of
view.
© Greenwich Roundtable 2009
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BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Acknowledgements
I am grateful for—indeed humbled by—the
depth of commitment of so many friends,
investors, and members. This was truly a team
operating at its best. It would be difficult not
to acknowledge first, Aleks Weiler, the leader
of our Best Practices Working Group. Aleks
went headlong into this project with a calm
determination and a pursuit of excellence. He
conducted all of the original focus groups that
cut across investor types and asset classes and
wrote the first draft. Ed Barksdale, a GR trustee
and Chairman of the Education Committee, set
the tone for the discussion when he suggested
that we emphasize the qualitative aspects of
portfolio construction. For more than two
years he generously opened the doors of his
offices for this diverse committee to meet. To
say that Rusty Olson was invaluable would be
an understatement. His clear thinking and his
clean writing style transformed this work into
a readable, enjoyable summary. His unselfish
respect for other opinions served to inspire others to do the same. Meanwhile, GR staff editor,
Alex Poletsky, was Rusty’s mission control.
This former newspaperman tirelessly rewrote
and negotiated over 20 drafts. Mark Silverstein
provided most of our guidance on managing
risk. His practical common sense approach
was only exceeded by his humility and goodnatured cooperativeness. Ray Gustin provided
a lot of our intelligence on hedge funds. His
ability to articulate the nuance was invaluable.
PORTFOLIO CONSTRUCTION
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On her weekend retreats in New Hampshire,
Lyn Hutton edited several drafts and provided
many innovative insights. Lyn often provided a
middle way to reconcile the philosophical differences between the quantitative and qualitative approaches. Bob Hunkeler, also a trustee of
the Roundtable, kept us focused on the realities
of the investment trustee’s experience. It was his
idea to write with an eye on educating trustees
who incur the liability and provide governance.
Finally, Nathan Fischer opened our minds to
organizing the portfolio along functional rather
than asset class lines.
I
“
nvestor education is
one of the greatest needs in
the marketplace.
”
—Stephen McMenamin
Executive Director
We are deeply grateful to the members of the
original focus group. Peter Bernstein challenged
us to show how to “play by ear.” Charley Ellis
urged us not to look at our neighbor’s work.
Clark Binkley unlocked the world of timber,
and John Hill guided our view on energy. Rian
Dartnell painted the picture from the private
investor’s view. Peter Lawrence, Sue Carter,
and Alexis Palmer took us on an insider’s
tour of the venture and private capital markets. Barry Sternlicht gave us a foundation to
build our view of real estate. Neal Triplett and
Mary Cahill offered the endowment perspective. We also appreciate the editorial insights
of Ray Dalio, Mark Casella, Don Raymond,
Afroz Qadeer, John-Louis Lelogois, and Wim
Kooyker.
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3
Introduction
“By three methods we may learn wisdom. First,
by reflection, which is noblest; second, by imitation, which is easiest; and third, by experience, which is bitterest.”
—Confucius
each alternative investment grouping: hedge
funds, private capital, real estate, and natural
resources. In each case we discuss the various
sub-styles of each grouping, issues around funding, and idiosyncrasies particular to each.
Greenwich Roundtable members practice a
different investing approach with an active
management style in alternative investments
such as hedge funds, private equity, real estate,
and commodities. We have written on the art
and science of finding, evaluating, and hiring
talented managers (the three Best Practices in
Hedge Fund Due Diligence white papers).
The final chapter on governance expands on
some practical elements to bringing about a
solid fiduciary structure. In all, we stress that
we should strive to do what is right for our
institution and not what others are doing.
We now turn our attention to building and
managing a portfolio of alternative investments.
We entered the project with the simple notion
that there is no one right way to craft a portfolio. We manage portfolios based on the needs
of our institutions, not by market conventions.
Also, we determine our own appropriate risk
levels. Most importantly, as the Roman philosopher Seneca said almost 2,000 years ago,
“When a man does not know what harbor he is
making for, no wind is the right wind.”
Chapter 1 distills the philosophical framework
behind best practices in portfolio construction
into two basic principles: Collect quality partners opportunistically, and give top priority to
risk management is a sine qua non of success.
Chapter 2 covers the practical side of building
a portfolio of alternative investments. We discuss building portfolios based on fundamental
economic drivers rather than conventional asset
class definitions or statistical constructions.
Chapters 3 through 6 cover the specifics around
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Conversations on all of these topics began two
years ago and took on greater importance early
in 2008 when our symposia speakers’ darker
prognostications became reality. We sat down
early in the summer of 2008 to begin the work
of speaking to the members and friends of the
Greenwich Roundtable in the same spirit we
approached our other research: openness and
curiosity coupled with humility as we faced the
scope of the topic.
Throughout this paper you’ll see frequent uses
of “we” and “our.” These refer to investors
who are responsible for managing a portfolio
for an institution or themselves. It is for them
that this study has been written.
Overall, we hope that you find this publication
helpful in navigating your institution through
the calm and the storms and safely into port.
Aleksander Weiler, CFA
BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Table of Contents
Chapter 1 – Building A Successful Portfolio Of Alternatives ...................................................... 7
What Are Alternative Investments? .................................................................................... 7
Why Consider Alternatives? .............................................................................................. 7
Common Characteristics Of Alternative Investments ......................................................... 8
Hedge Funds ........................................................................................................... 9
Private Capital ........................................................................................................ 9
Real Estate ............................................................................................................ 10
Natural Resources ................................................................................................. 10
Best Practices In Alternative Investments: The Principles .......................................................... 12
Collect Quality Partners Opportunistically ...................................................................... 12
Listen To And Learn From Our Managers ............................................................ 14
Be Contrarian When Appropriate ......................................................................... 14
Innovate ................................................................................................................ 15
Risk Management Is A Key To Success ............................................................................ 15
Diversify................................................................................................................ 16
Maintain Enough Liquidity To Stay The Course ................................................... 18
Accept And Plan For The Eventuality That We Are Wrong ................................... 19
Conclusion ...................................................................................................................... 20
Chapter 2 – Putting It All Together: The Policy Portfolio ........................................................ 21
The Investment Policy Statement ..................................................................................... 21
The Policy Portfolio ......................................................................................................... 21
Existing Best Practices: The Old School.................................................................................... 22
Recent Best Practices: The New School .................................................................................... 23
Economic Environments And Their Impact On Asset Prices ............................................ 24
Growth ................................................................................................................. 25
Inflation ................................................................................................................ 26
Deflation ............................................................................................................... 26
Investment Strategies Under Different Economic Scenarios .............................................. 27
Skill-Based Diversifiers .......................................................................................... 28
Making The Actual Investments ............................................................................................... 28
Rebalancing .......................................................................................................... 29
Summary .................................................................................................................................. 29
Chapter 3 – Constructing A Successful Hedge Fund Portfolio .................................................. 31
Hedge Fund Styles ........................................................................................................... 31
The Beta In Hedge Funds................................................................................................. 33
What Have Hedge Funds Produced?................................................................................ 34
Best Practices In Investing In Hedge Funds ............................................................................... 36
Selecting Investments ....................................................................................................... 36
Sizing Positions ................................................................................................................ 38
Fat Tails And Black Swans .............................................................................................. 38
Forming A Portfolio Of Hedge Funds .............................................................................. 39
Portable Alpha................................................................................................................. 40
Is Portable Alpha Broken? ............................................................................................... 41
Terminating A Hedge Fund Account ............................................................................... 42
Dealing With Risk ........................................................................................................... 42
PORTFOLIO CONSTRUCTION
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5
Table of Contents
Chapter 4 – Constructing A Successful Private Capital Portfolio .............................................. 45
Investment Strategies ....................................................................................................... 45
Structural Characteristics Of Private Capital ................................................................... 46
What Have Private Capital Programs Returned? ............................................................. 47
Best Practices In Private Capital Portfolio Construction ........................................................... 48
Selecting Investments ....................................................................................................... 48
Combining, Sizing, And Rebalancing Positions ........................................................................ 50
Chapter 5 – Constructing A Successful Real Estate Portfolio.................................................... 52
Best Practices In Real Estate Portfolio Construction ................................................................. 53
Selecting Investments ....................................................................................................... 53
Combining, Sizing, And Rebalancing Positions ................................................................ 54
Value-Added Real Estate .......................................................................................................... 54
Leverage ................................................................................................................................... 55
Chapter 6 – Constructing A Successful Natural Resources Portfolio ........................................ 56
What Should A Natural Resource Program Produce?............................................................... 57
Best Practices In Natural Resource Portfolio Construction ....................................................... 58
Passive Investing .............................................................................................................. 58
Discretionary Commodity Managers ............................................................................... 59
Private Energy ................................................................................................................. 60
Timberlands .................................................................................................................... 60
Combining, Sizing, And Rebalancing Positions ................................................................ 61
Chapter 7 – Good Governance: The Crucial Element............................................................... 62
What Is Governance? ....................................................................................................... 62
Why It Matters ................................................................................................................ 62
Functions Of The Investment Committee ................................................................................. 63
The Staff/Committee Relationship............................................................................................ 63
Committee Meetings ................................................................................................................ 64
Evaluating Performance ........................................................................................................... 64
Meeting Topics ........................................................................................................................ 65
Meeting The Managers ............................................................................................................ 65
Working With New Committee Members ................................................................................ 66
What Can Smaller Funds Do For Staffing? ............................................................................... 66
Bibliography ............................................................................................................................ 69
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BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Chapter 1 – Building A Successful
Portfolio Of Alternatives
“When the facts change, I change my mind.
What do you do, sir?”
—John Maynard Keynes
In this chapter we examine alternative investments at a high level and look to answer three
main questions:
• What are alternative investments?
• Why consider alternative investments?
• What are the best practices investors should
use in approaching them?
What Are Alternative
Investments?
While long-only purchases of common stocks,
bonds, and cash dominate most portfolios, they
represent only part of the full range of investment possibilities. In the simplest sense, alternative investments are everything that is not one
of these three traditional investments.
Despite its name, alternative investing has
been a “traditional” way to make a lot of
money. The most successful investors have
invested without restrictions—whether across
asset classes or investment styles. They did so
because constraints are expensive and reduce
net portfolio returns. Constraints reduce the
number of tools available to successfully profit
from a given environment. Great fortunes—the
Medicis in the Renaissance, the Rothschilds
in the 1700s and 1800s, or American capitalists (Mellon, Carnegie, and Rockefeller)—were
made by adapting to the opportunities apart
from a particular asset class.
Why Consider Alternatives?
The growing use of alternative investments
arose from a simple truth: they represented
some of the best investment opportunities
for improving chances of generating sufficient
returns to meet most institutions’ obligations.
PORTFOLIO CONSTRUCTION
Investors’ expectations for returns became
greater than what was readily available in the
market, so many investors stretched for return,
sometimes unrealistically.
I
“
n the simplest
sense, alternative
Historically, publicly traded equities and fixed
income securities met investors’ needs. Starting
points matter, however, especially for U.S. equities. T rose to levels incompatible with a future
repetition. By 2000 equity valuations were off
the map. Price-earnings ratios could hardly rise
further. Unsurprisingly, from 2000-2007 (prior
to the market’s collapse in 2008), the real annual
return on the S&P 500 was a negative 1.1%
while the real return on the Lehman Brothers
Aggregate bond index1 was 3.8%.
investments are everything
that is not common stocks,
bonds, and cash.
“
Such returns led investors to become more
global in their asset allocation, including larger
allocations to alternative investments, many
of which provided better returns during this
interval, as did non-U.S. stocks. Real returns
during 2000-2007 were 2.8% on EAFE2 and
12.5% on the emerging markets. However, their
returns brought their P/Es close to those of the
S&P 500—all based on earnings that appeared
increasingly unsustainable as 2008 progressed.
There has been little chance of traditional
investment categories meeting return hurdles—
such as pension assumptions of 8% annualized returns, endowment targets of 5% real
annualized returns, and foundation needs
of 10% nominal annualized returns. With
10-year Treasury yields below 3% in February
2009 and around 1.7% for the corresponding
Treasury Inflation-Protected security (TIPs),
it’s difficult to envision fixed income providing
much opportunity for return unless we encounter outright deflation.3 Asset sponsors will be
forced to change expectations of returns to
more realistic levels.
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”
T
he most successful
investors have invested
without restrictions—
whether across asset classes
or investment styles.
”
1
Renamed the Barclays Capital Aggregate
Index on Nov. 3, 2008.
2
The Europe, Australasia, and Far East
Index from Morgan Stanley Capital
International. An unmanaged, marketvalue weighted index designed to measure
markets.
3
In “Estimating the Stock/Bond Risk
Premium” in the Journal of Portfolio
Management, Volume 29, Number 2,
pp. 28-34, Lacy H. Hunt and David
M. Hoisington note that “contrary to
intuition, historically bonds have outperformed stocks when bond yields started
at a low nominal level” (p. 33) as this
has presaged periods of “severe deflation,”
which hurts equities and benefits bonds.
2009
7
Chapter 1 – Building A Successful
Portfolio Of Alternatives (cont.)
Investment management has always been about
solving clients’ problems. The profession did
so by benchmarking and indexing (alpha-beta
separation), equity-heavy mean-variance optimized Policy Portfolios, and increasing manager
specialization. The difficult task of finding talented managers and of diversifying portfolios
into alternative investments became the next
evolutionary step.
A
“
n alternative
manager must earn
4.
substantially higher returns
before fees than a traditional
Common Characteristics Of
Alternative Investments
manager in order to provide
There are a number of characteristics common
to most alternative investments:
investors with the same net
1.
returns.
”
2.
4
Qualified institutional investors for 3(c)
(7) funds (500 investor limit) must have
$25 million in “investments.” Qualified
institutional investors for 3(c)(1) funds
(on-shore, 100 investor limit) must have
$5 million in net worth. Both are open to
individuals as well as institutions.
5
New regulatory and legislative action
is likely to result in greater oversight of
hedge funds and other alternative investment managers. Source: Price Waterhouse
Coopers.
8
2009
3.
The objectives are achieved by using techniques, instruments, markets, assets, and
capital structures unavailable to traditional
investors. Techniques include shorting, control positions, activism, private ownership,
and operational improvements. Instruments
include derivatives and hybrid securities.
Markets and assets include private markets, direct real estate, direct ownership
of companies, commodities, and foreign
exchange. Capital structures include leverage achieved directly from borrowing or
indirectly through derivatives.
The investment objective tends to be high
absolute returns, with low or moderate
correlations to public markets. Nearly all
alternative investments follow a risk-centric
investment process. They focus on downside risk designed to minimize the left
tail and to achieve favorable risk/reward
tradeoffs. This is in contrast to the relative performance and benchmark-centric
approach of traditional investments.
Unconstrained mandates (relative to traditional managers) are typical for marketable
alternatives. Most managers of illiquid alternatives (private equity, real estate, natural
resources) have more defined techniques,
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5.
6.
7.
markets, and mandates to exploit their specialized talents. Managers of liquid alternatives are given more flexibility to move to
the opportunity.
Liquidity, if any, tends to be poor. Private
equity, natural resource partnerships, and
real estate require commitments that extend
to 10 years or longer. Many hedge funds
require lockups of at least a year; allow
redemptions only quarterly or annually
with anywhere from 65 days’ to six months’
notice; and have up to 30 days from the
redemption date to actually pay out the
requested funds. Gates and side-pockets for
illiquid holdings are not uncommon.
The incentive structure differs from traditional investments through higher management fees plus an emphasis on performance
fees. Hurdle rates, clawbacks, and redemption provisions, if any, differ from type to
type and manager to manager. The presence
of a performance fee acts as an incentive to
investment talent and encourages managers
to take risks. Most managers of common
stocks charge fees of 0.5% to 1%. Fees for
many alternative managers are 1%-2% plus
15%-20% of nominal profits. An alternative manager must earn substantially higher
returns before fees than a traditional manager in order to provide investors with the
same net returns.
Most are private placements, with many
being partnerships and restricted to accredited investors or qualified purchasers.4
Many managers of alternative investments
are not registered with the U.S. Securities and
Exchange Commission (SEC). Institutional
participation in their funds is limited to
qualified purchasers.5
Following is a summary of different kinds of
alternative investments. Each is described in
more detail in subsequent chapters.
BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Chapter 1 – Building A Successful
Portfolio Of Alternatives (cont.)
Hedge Funds
What differentiates hedge funds from traditional investment partnerships isn’t necessarily
the invested instruments, public equities, fixed
income, and cash; rather, it’s the way they’re
traded.
Short selling is actively employed, leverage
is commonly used, and superior risk profiles
are sought using derivatives and active hedging. Managers possess relatively unconstrained
investment mandates. They are free to invest
wherever they can find the best risk/reward
tradeoff. In practice, however, they tend to
confine themselves to strategies and markets
in which they are especially proficient, which
vary widely from manager to manager. Finally,
the objective of the investment process differs
from traditional investing. Rather than outperforming a benchmark on a relative basis, hedge
funds typically focus more on producing high
absolute returns with low or modest correlation to equities. The notion that hedge funds
should always make money is simply not so.
In addition to record frauds, large losses by
leveraged funds, and investor needs for liquidity, this misunderstanding added to the spike in
redemptions at the end of 2008.
Private Capital
This involves direct equity investment in private
companies, turning public companies private, or
making private investments in public companies.
Methods include seeding and establishment of
businesses through venture capital, the expansion of smaller to mid-sized enterprises through
growth capital, or buyouts of mature businesses.
Some investors also include private fixed income
and distressed debt strategies in this category.
The industry divides it into four main strategies:
1. Private equity: These are managers who
buy companies—public or private—and
PORTFOLIO CONSTRUCTION
2.
3.
run them privately. They aim to generate above-market returns by effectively
implementing operational improvements
or growth strategies at portfolio companies. Some generate returns through
financial engineering—as by modifying a
sub-optimal capital structure, usually by
increased borrowing. Roll-up strategies
build a large company in a fragmented
industry by unifying many smaller enterprises. Some managers focus on companies
that are headed toward or in bankruptcy.
Venture capital: The business of venture
managers is finding, funding, and nurturing startup businesses that successfully
commercialize innovations. Historically,
venture investing has been focused in the
information technology, telecommunication, media, and health care sectors in the
United States. A single investment’s astronomical returns (greater than 10x) can pay
for multiple investments that break even or
fail. Growth capital can be thought of as a
subset of venture investing with a focus on
post-early stage companies.
Secondary funds: Historically, investors
have made commitments to private equity
and remained with the manager until the
completion of the partnership. Sometimes
immediate liquidity needs arise and secondary fund managers step in to buy these
partnerships normally at a discount. Some
commitments are fully funded; others
are still calling down funding from their
investors. Secondary funds can be beneficial to the seller, who gets immediate cash
and is released from further obligations
to honor capital calls. The buyer gains
access to otherwise closed managers, or
can top up allocations to existing names,
or can make an immediate full investment
to private equity.
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“
ather than
outperforming a benchmark
on a relative basis, hedge
funds typically focus more
on producing high absolute
returns with low or modest
correlation to equities.
2009
”
9
Chapter 1 – Building A Successful
Portfolio Of Alternatives (cont.)
4.
R
“
eal estate can
improve portfolio efficiency
because over the years it
has shown only modest
Private debt: Fund managers may also
infuse capital into a company by offering senior debt secured by collateral or
mezzanine debt; the latter typically earns
the highest coupon of debt in the capital
structure in exchange for being the most
junior obligation while collateral offsets the
risk of the former. There are a number of
distressed strategies such as gaining control
of a company through debt instruments,
restructuring the company in bankruptcy,
and exiting the investment by selling the
new equity.
property) as well as distressed projects fall
into this category.
Real estate tends to be a highly cyclical industry.
In good times vacancies are low and so are capitalization rates. The overbuilding that follows
eventually depresses returns and leads to underbuilding until supply and demand equalize. The
economic cycle, especially the local one, affects
returns more than other alternative investments.
Real estate can improve portfolio efficiency
because over the years it has shown only modest
correlation with U.S. equities.
correlation with U.S.
Real Estate
Natural Resources
equities.
The third major category of alternative investments is the most easily understood and is
divided into roughly three main strategies:
The fourth major category of alternative investments is natural resources. This involves liquid
and illiquid investments in commodities and
commodity-focused companies. As in the case
with real estate, natural resources tend to have
low correlations with traditional assets.
”
1.
2.
3.
10
2009
Core: Long-term ownership and management of income-producing properties.
These include fully leased office, retail, or
industrial properties in prime locations.
They’re coupled with light to modest (up
to 35%) leverage, targeting high singledigit returns. Long-term depreciation from
property as a result of use or obsolescence
requires that capital expenditures be built
into cash flow projections.
Value-added: Buying properties to upgrade
them and resell them within three to seven
years as core real estate. Such funds include
moderate leverage (up to 60%-65%) and
low to mid-teens internal rate of returns
(IRRs) net of fees to investors. Value-added
is riskier than core real estate because of
the higher leverage, and the risks in redevelopment.
Opportunistic: Investment in select opportunities, often with above 70% leverage,
usually on individual properties. The goal
is to produce high-teen returns and sometimes more. Greenfields (undeveloped
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This category is divided into four main strategies:
1.
2.
Energy partnerships: Private capital focused
on the global energy industry. There are
five main categories: resources (exploration
and production), equipment (the leasing of
drilling rigs, transportation, and extraction
heavy machinery), services (engineering,
IT, and staffing), infrastructure (transmission lines, power supply, and pipelines),
and alternatives or opportunistic investing
(renewable energy such as solar, hydroelectric, wind, nuclear power, or specific
opportunities).
Timberland: Partnerships that acquire,
hold, develop, and harvest forests. Returns
come from organic growth, good forestry
practices, and selling at appropriate times.
As with other natural resource investments, timber prices and returns tend to
be cyclical.
BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Chapter 1 – Building A Successful
Portfolio Of Alternatives (cont.)
3.
4.
Commodity indexes: Passive investment in
commodity index futures or swaps. As with
equities and fixed income, enhanced indexing—the act of actively making adjustments away from index weightings—is
often employed.
Active commodities: Hedge funds and private equity with a dominant investment
focus on commodities or commodityfocused companies.
Liquidity for investments ranges from excellent
(daily) for futures on commodity indexes to
very poor for energy partnerships and timberland (typically 10 to 15 years).
S
“
ystems traders do
not anticipate, they follow
the system. Discretionary
traders develop a point
of view usually based on
fundamental analysis.
”
—Ken Tropin
PORTFOLIO CONSTRUCTION
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11
Best Practices In Alternative Investments:
The Principles
Management of alternative investments is characterized by two principles, which we identify as
best practices in alternative investment portfolio
construction. Both principles have three important subsets:
U
“
nlike traditional
1.
investments, the quality
of the manager matters
2.
more than the asset class
in making decisions about
alternative investments.
”
Collect quality partners opportunistically
a. Listen to and learn from our managers
b. Be contrarian when appropriate
c. Innovate
Risk management is a key to success
a. Diversify among asset classes,
strategies, and managers
b. Maintain enough liquidity to stay
the course
c. Accept and plan for the eventuality
that we are wrong
Collect Quality Partners
Opportunistically
6
Source: Commonfund.
7
What makes up alphas – some combination of market making, insurance provision, liquidity provision and security selection and/or market timing skill, or perhaps
simply luck – is beyond the scope of this
publication.
8
Nontraditional betas arise as trading
strategies mature, become more widely
understood and can be largely replicated by
simple mechanical approaches. Examples
would include foreign exchange carry,
long-term trend-following, convertible
arbitrage and merger arbitrage. Research
includes academic work by Mitchell and
Pulvino ((2001) “Characteristics of Risk
and Return in Risk Arbitrage,” Journal of
Finance, Vol. 56, No. 6 (December: 21352175), Andrew Lo and Harry Kat along
with a large body of practitioner work.
12
2009
Unlike traditional investments, the quality of the
manager matters more than the asset class in
making decisions about alternative investments.
Build portfolios from the bottom up by opportunistically identifying and allocating to quality
managers, and only quality managers. While in
search of quality managers, we must “stick to
our knitting.” That is to say, stick to our mission
and objectives, stop looking at what our neighbor is doing, and don’t chase returns that might
have risks inconsistent with our basic strategy.
Traditional investment managers work under
the disadvantages of investing in the most
efficient markets and long-only constraints.
The best domestic fixed-income managers add
merely 20 basis points compared to the median
while assuming considerable market risk (i.e.
most of their return is beta, not alpha). The
same could be said of the best managers of U.S.
large cap equities which add not quite 1½%.6
Even in international equities, the value-added
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for top quartile managers is little more. Most
results can’t exceed passive indexation.
Contrast this with alternative investments.
Allocation and access to top-tier illiquid alternative investment managers is the primary difference among top-performing funds even after
adjusting for the additional risks and illiquidity
assumed. The spread between top quartile and
median managers in most alternatives is very
large, and the spread between even second and
third quartile is huge on a raw return basis. It is
often better to have zero invested in an alternative strategy than to have the target allocation
invested with a mediocre manager.
What Is Quality And Does It Matter? One
answer to “What is quality?” paraphrases the
late U.S. Chief Justice Potter Stewart’s 1964
opinion on obscenity (“I know it when I see it”).
But the answer to the second question is much
more concrete: Does quality matter? Yes!
The Greenwich Roundtable’s first three Best
Practices publications examined the question
of ascertaining what quality is for hedge fund
managers. The capital asset pricing model holds
that returns can be broken down into passive
market exposure (beta) and active management
(alpha). Mathematically, “quality” therefore
means high and consistent alphas.7 Applying
this definition mechanically, however, ignores
the possibility of the alpha being the result of
simple mis-measurement or parameter misspecification. There is considerable academic
and practitioner work suggesting that many
alternative investments contain exposures to
both traditional and nontraditional betas as
well as to other risk factors. These include size
and style exposures, interest rate term structure, momentum, short volatility, corporate
events, liquidity, and leverage.8 Nor does it
BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Best Practices In Alternative Investments:
the Principles (cont.)
answer the question of whether the returns
were luck or genuine skill.
The process of investment manager selection—
evaluating people, culture and business structure, operations, value proposition, and identifying skill—applies to all asset classes and
sectors, not just alternatives. For liquid alternatives, the three previous Best Practices in Hedge
Fund Due Diligence publications offer some
practical guidance at not only finding but doing
the hard work or ascertaining whether real skill
is present.
Ultimately, after all the due diligence and reference-checking is done, the decision boils down
to investor judgment and intuition regarding
whether the person or team is a money maker
who can maintain a durable competitive advantage, possesses integrity, is personally invested
and motivated, is a fair partner, and offers a
reasonable value proposition. Past performance
is a clue to quality, as are other markers such
as time spent at proven firms and academic success. But how managers achieve their results is
more relevant to answering the main questions:
is it probable that they will replicate their past
success, and do I get to keep a sufficient portion
of it to justify committing capital and bearing
the inherent risks?
How Do We Get Quality? Access to quality
is neither democratic nor egalitarian. Whom
we know and, more importantly, how we are
known, matters. If we as long-term investors
want excellent managers to work hard for us
and offer their insight, we need to make a commitment and demonstrate “staying power”—
that we are able to stay the course.
Since quality is scarce and has historically been
PORTFOLIO CONSTRUCTION
difficult to access, it is often best to allocate
opportunistically when capacity becomes available regardless of our particular view of the
asset class, sector, or strategy. The most successful investors willingly rebalance their portfolio by selling liquid positions in the associated
or proximate asset class or use derivatives to
stay reasonably within their Policy Portfolio.
W
“
ith top quality
managers, it is often best
How Do We Keep Quality? Quality managers
are in high demand and can extract better economics for themselves—either through higher
fees or less liquidity for investors. Typically,
such funds are closed to new investors or are
adjusting liquidity provisions to attract only
investors that have staying power. Both the
supply of investment talent and the demand for
it fluctuate over time. Between 2003 and 2008,
demand outstripped the supply and investors
had to give up larger and larger portions of the
economics to managers. Starting in the fall of
2008, this balance began shifting increasingly
in the investors’ favor.
How do we gain confidence that the manager’s
interests are aligned with ours? First, we prefer
a fee structure that is more biased toward the
performance fee. This aligns incentives more
strongly. Among other advantages, it can lead
the manager to be more responsible in raising
costs. Second, a manager’s principals should
demonstrate their commitment by having a
meaningful portion of their personal net worth
invested in the fund. While this is often difficult
to verify, the general partner’s or fund manager’s capital commitment should represent a
meaningful commitment. Terms should also
provide a key person clause9 and other “investor friendly” provisions. Third, a manager
should be building an investment culture that
encourages cooperation, competition, mentoring, and a climate of mutual respect.
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to allocate opportunistically
when capacity becomes
available regardless of
our particular view of the
asset class.
”
9
The clause prohibits the fund manager
from making new investments until an
acceptable replacement is made for a key
executive who ceases to devote a specified
time to the partnership and may result in
the winding up of the fund.
2009
13
Best Practices In Alternative Investments:
the Principles (cont.)
Listen To And Learn From Our
Managers
Hiring a manager is like getting married. Both are
characterized by the seriousness of the decision to
say “I do,” the need for work and time to build a
relationship, and the pain of parting company.
B
“
eing contrarian
means that you risk being
wrong, being alone,
and having much higher
volatility. If you’re not
Getting to know our managers is a two-way
street requiring plenty of communication. We
need to understand how they are going to think
or react to certain circumstances. They need to
know some of the same about us. It is best to
treat the due diligence process as never-ending.
We should be constantly verifying that the managers are playing the role in the portfolio that
we expect.
lonely, you’re probably
not a contrarian. Being
contrarian takes the courage
to be wrong and alone for
extended periods of time.
Contrarian investing is not
for sissies.
”
—Peter Bernstein
10
Michael Mauboussin states that the
“crowd is usually right” in his speech
at the Greenwich Roundtable symposium
“Contrarian Investing: The Psychology of
Going Against the Crowd,” Feb. 24, 2005.
Also see The Wisdom of Crowds by James
Surowiecki.
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2009
We must understand the risks they are taking since these will change over time. A balance between trust and skepticism is needed.
Managers in certain strategies may see what
they do as highly proprietary and confidential
and may be reticent to be as sufficiently transparent unless they understand our need to manage the whole portfolio of which an individual
manager is only one part.
Preparing well for the meetings, offering honest and forthright feedback, are all components
of building this kind of relationship. It is more
important to listen, listen some more, and
continue listening. The manager will likely be
examining us as well. If we set the standard
high during the due diligence phase by being
open and forthright, we have a better chance of
building a strong overall relationship.
Some managers can be original thinkers, and
others may be early warning indicators. Some
are ahead of investment trends, expert in spotting untapped opportunity. Listening to our
managers and understanding the quality of
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information and the accuracy of their predictions will go a long way in helping us build our
own portfolio and make the whole greater than
the sum of the parts.
Be Contrarian When
Appropriate
Great long-term track records are not built by
being like everyone else. They are the result
of purchasing high quality assets at favorable
prices, often when others perceive them as low
quality. The appeal of alternative investments
is the lack of consensus. There is more room
for non-consensus thinking within the investment structures they employ. A best practice in
portfolio construction is, selectively and when
appropriate, to be contrarian.
The only way to “pay a little/get a lot,” is to buy
when others are selling and vice versa. While a
value bias is part of being contrarian, it is not
the whole story. Being a true contrarian is not
about reflexively betting against the consensus.
It’s about betting against the consensus when
our assessment of fundamentals differs materially from those priced into the markets.10
The 2007-2008 success of shorting the subprime asset-backed securities index was about
a divergent view of home equity borrowers.
The consensus held that residential mortgage
borrowers represented little credit risk because
the underlying collateral—their houses—always
went up in value. But small disturbances in
the rates of house price appreciation, not even
requiring actual losses, would result in material
default risk.
At any given time, there are hot asset classes
sporting high valuations while other sectors
languish with cheap or distressed pricing.
Alternative investments are no different. An area
BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Best Practices In Alternative Investments:
the Principles (cont.)
is undercapitalized, with few investors showing interest, so participants within it have to
attract investors with high yields and/or low
prices. Capital then flows in, the opportunity becomes less attractive until it becomes
the new hot area and should be avoided.
Venture capital was a great investment in the
early 1990s but it was terrible in 1998-1999.
Convertible arbitrage in the late 1990s was
great while in 2005 it was terrible.
Like a contrarian benefiting from shorterterm dislocations, executing on this practice
requires an investment culture supportive of
innovation and long time horizons (especially
the ability to lock capital up over a decade or
more). It also requires a way to source fresh
ideas. Listening to our best and brightest managers is a good place to start. And it requires
an acutely tuned appreciation for where the
idea is in the spectrum.
Talking to managers across a wide range of
sectors, geographies, and strategies gives institutional investors a unique vantage point. It
helps us understand the differences in pricing,
fundamentals, and ultimately opportunities.
The key is to use this information to our
advantage.
Innovation in investment management is about
moving to areas rich in opportunities and poor
in capital. While alternatives currently offer
some of the best chances of meeting acceptable
return levels, most of the strategies and substrategies are relatively well understood and no
longer cutting edge. There may be a time when
most alternatives could be too widely owned
and become unattractive.
Innovate
The success that some institutions enjoy through
alternative investing is a result of the institutionalization of a culture of innovation. Strong
results at the leading institutions are the result
of reaping what was sown a decade or more
ago. We should not invest in what these institutions are investing in, but rather invest how
these institutions are investing. That is to say,
remain open-minded and innovative.
Earning great returns means being invested when
the idea or market is cutting edge and riding the
compression of risk premiums until it reaches
mainstream. Take for example the heavy use
of alternatives by endowments. Hedge funds
were on few people’s radar screens in the 1980s
when these investors began allocating to them.
Returns to the now-mainstream strategies like
merger arbitrage or convertible arbitrage were
sometimes in the 25%-30% range. Timberland
was bought with 12%-15% yields.
PORTFOLIO CONSTRUCTION
“
I
nnovation in investment
management is about moving
to areas rich in opportunities
and poor in capital.
”
Risk Management Is A Key To
Success
Effective risk management is crucial to successfully managing a portfolio. It is often viewed
as a distinct responsibility, but it’s executed
most effectively when it’s an integral part of the
investment process. The best practitioners consider risk management and portfolio management as two sides of the same coin. Successful
investors are good at assessing the relationship
between potential return and downside risk. To
make solid investment decisions, it’s impossible
to ignore risk. Successful investors understand
and manage risk in several ways:
1.
2.
At individual decisions: They integrate risk
analysis into individual investment manager selections or terminations.
At the portfolio level: They manage their
portfolio to a risk target or constraint.
Based on their objectives and risk tolerance,
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Best Practices In Alternative Investments:
the Principles (cont.)
U
“
nderstanding
risk in alternatives is a
qualitative process.
”
3.
they determine a specific amount of
downside they are willing to suffer. They
then construct a portfolio that optimizes
the mix of opportunities within that risk
limit. The most effective investors work
to adjust their portfolio risk as a function
of the quality of investment opportunities available and their outlook for the
markets. This approach limits excessive
leverage and manages liquidity so the
investor isn’t forced to sell assets at an
inopportune time.
As a feedback loop: As events unfold,
investors can determine if their ex ante risk
expectations were accurate to the given
market conditions. If assumptions are off,
they can recalibrate them to improve the
process should the delta be considered nonrandom. The more turns of this process, the
better investors can deal with future risks
and opportunities.
Key points to remember:
• Liquidity risk takes two forms—the
ability to access cash when we need it,
and if we borrow money, ensuring that
our loan can’t be called at a time when
we need the money.
• Time becomes a risk if we invest in
opportunities requiring a long horizon
and we lack the ability to wait for a
positive return.
• There are many approaches to risk
management. Investors need to
find what works for them and their
organization.
• Any risk analysis is only as good as
its data and assumptions—garbage in,
garbage out.
• Risk measurement is not risk
management.
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2009
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• The cost of a “rainy day” portfolio is a
drag on returns. Insurance is a governing
board decision and is only cheap and
effective before the storm hits.
• Effective investors use a variety of risk
metrics to understand their exposures.
Mistakes investors make:
• Too much leverage!
• They commit to one type of risk
measurement without considering other
potential sources of trouble.
• Risk analysis may be too dependent on
historical data without consideration of
root causes of risk and how the future
could differ widely from the past.
• Mismatch of borrowing and lending
liquidity.
• Investing without adequate understanding of the fundamentals or the players
involved.
• Ignoring counterparty risk.
In the end, risk control is the CIO’s responsibility and can’t be handed off.
Diversify
Four themes underlie this principle:
1.
2.
3.
4.
Diversification is a qualitative assessment;
Differences in asset class, sector, strategy,
and manager weightings reflect demonstrable differences in characteristics;
Flexibility around the Policy Portfolio is
important; and
Rebalancing is more for beta and other risk
measurements than for managers.
BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Best Practices In Alternative Investments:
the Principles (cont.)
Caveats About Applying Diversification: The
principle that some risks can be diversified
away applies equally to traditional and alternative investments, but it needs to be approached
differently with alternative investments.
For most alternatives the data are infrequent
(monthly or quarterly) and lack a standardized
calculation methodology (net vs. gross; IRR
vs. cash return). Also, the performance indexes
are less robust because of smoothed pricing,
voluntary reporting to indexers, and relatively
recent inception dates. Investors cannot form
statistically robust conclusions with the index
data, especially across asset classes. We should
be cautious about relying too heavily on quantitative measures.
The opportunistic nature of most alternative
investment managers further complicates the
analysis. Managers seek opportunities wherever
they may arise, leading to varying exposures
over time.
Investors must therefore deal with the possibility of an unintended concentration in market
risk exposures. For example, many different
managers currently view distressed credits and
companies as an attractive opportunity. Hedge
funds of marketable alternatives (event strategies), fixed income (distressed debt), private
equity (turnaround/distressed companies), and
even real estate portfolios (distressed sellers and
properties) are all likely to be developing highly
correlated distressed exposures. Compounding
this problem are changes in markets where
globalization and financial innovation have
increased correlations among asset classes. The
result is less diversification with increased
exposure to certain sectors.
The way to achieve true diversification with
PORTFOLIO CONSTRUCTION
alternative investments is to develop a deep
qualitative understanding of the managers—
what, how, and why they are making their
investment decisions—and form conclusions
based on reasoning and judgment. This applies
equally to initial and ongoing assessments. How
managers are currently thinking and positioned
is often far more important than historical factors. A hedge fund may have demonstrated an
historical beta of 0.9 to the S&P 500 Index.
But knowing that the manager is now bearish
and lowered the fund’s net exposure to 15%
is relevant to the risk profile of our portfolio.
Recently, for example, many multi-strategy or
equity oriented fund managers, who several
years ago had zero allocation to credit, may
now have portfolios dominated by credit and
minimal equity exposure. The strategy change
was driven by market conditions and opportunities. Once we understand these fundamentals,
we then understand more about the total portfolio risks and can decide to either retain them
or hedge appropriately.
I
“
nvestors should
embrace volatility. Build
a portfolio of strong
performers and the diversity
of the portfolio will dampen
volatility.
”
—Byron Wien
Portfolios generically contain three levels: the
asset class (the “bucket,” such as equities or
growth as we will see later), the strategy (publicly traded equities, hedged equity, or private
equity), and the individual managers selected.
All three should be diversified.
We achieve diversification in two ways: by
selecting uncorrelated investments and by sizing them appropriately. While an uncorrelated
position helps, even at 1% weighting, it does
not materially influence a portfolio’s overall
risk profile. The same position sized at 25%
changes it dramatically.
Position Sizing: How then do we size alternative investments? Successful investors must
make judgments based on their knowledge
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Best Practices In Alternative Investments:
the Principles (cont.)
T
“
he best long-term
investment performance is
earned by those who not
only survive market crashes
but have the ‘staying power’
to maintain fundamentally
sound positions and the
liquidity to invest when
others cannot.
”
of markets as well as the risks associated with
various strategies and individual managers.
Differences in sector and manager weightings
should always reflect demonstrable differences
in characteristics. Because it is difficult to demonstrate clear quantitative differences among
managers, equal weighting is often a reasonable
first step because it focuses the investment team
on what will make a difference in the portfolio.
For example, assume we have access to three
hedged equity managers, each with a different investment philosophy and process, all of
whom meet our quality standards. A logical
starting point would be to give each one-third
of our hedged equity allocation.
Investors should look to roughly equal-weight
both in terms of capital and risk in the portfolio. Judgment is used in determining the balance
between the two. This allows us to avoid the
false sense of precision generated by statistical
risk measures while benefiting from the insights
they can provide.
There are three caveats to an equal-weighting
scheme:
1. Since manager capacity may be limited, we
may not be able to get to equal weighting
in all investments. In those cases, we take
what we can get.
2. As we gain confidence in our managers over
time, we may have a greater sense of the
managers and a stronger sense of their return
characteristics. Having a higher weighting
for established, long-term investments and a
lower weighting for less proven investments
may be wise. Also, some thought should be
given to half positions in especially volatile
managers or strategies.
3. Most institutional investors use some sort
of Policy Portfolio to size allocations among
strategies. Policy Portfolios serve two vital
18
2009
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yet distinct roles: they establish a risk target and they represent our passive asset
allocation. Risk tolerance should be set
independent of how risk is obtained (i.e.,
what investments are selected). Alternative
investments allow us to squeeze more return
from the same level of aggregate risk.
Maintain Enough Liquidity To
Stay The Course
The best long-term investment performance is
earned by those who not only survive market
crashes but have the “staying power” to maintain fundamentally sound positions and the
liquidity to invest when others cannot.
Liquidity means having an unfettered ability
to deploy capital to an opportunity. No matter
how correct we are in our views on the long
term, our ability to stay in the trade when the
going gets rough ultimately decides whether
we had adequate liquidity to make the investment in the first place. History is replete with
sad tales of investors who were forced to sell
into turmoil but who, if they had just been able
to hang on—had staying power, would have
realized gains consistent with their objectives.
It is ironic that during the 2001-2002 routs
in stocks, investors who were locked-up often
did better because they were unable to heed
the emotional desire to sell. Staying power, of
course, is more than staying in the investment—
it is the ability to adhere to the long-term
investment objectives and not abandon those
objectives to meet shorter-term needs.
Ultimately, investors have two sources of liquidity: internal and external.
Internal Source of Liquidity. Within most institutional settings, the first source of liquidity is
the authorization of the board (or investment
BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Best Practices In Alternative Investments:
the Principles (cont.)
committee or capital provider generally) to take
risk. The board understands the needs of the
organization, offers continuity, and sets investment policy. The investment team is charged
with executing that investment policy, and,
given the team’s expertise and constant contact
with managers and the marketplace, is in the
best position to ascertain the most efficient and
effective implementation of investment policy—
which risks are likely to be rewarded. It is easy
to see why good governance is essential to good
risk-taking. It brings the two sides together in a
way that makes the whole greater than the sum
of its parts. This is why CIOs should spend an
inordinate amount of time making sure their
board is knowledgeable and well informed.
the hard way when the credit markets froze
in 2008. This forced them to liquidate investments in order to meet operating costs and
other obligations. If we are invested in swaps,
we need a special staff person looking after all
of the liquidity issues—such as International
Swaps and Derivatives Association negotiations (the governing document between broker
and investor), margin calls, capital calls and
distributions, and operating budget payments.
Done well, liquidity management can be a competitive advantage. Done poorly, it is the end of
many investors. Ask ourselves if we can truly
devote the necessary resources to managing
liquidity well. Consider scaling back our efforts
if the answer is no.
A key responsibility of the CIO is the education
of the board and appropriately involving board
members in decision-making. Time, forthright
communications, and proper expectation-setting are needed to build a solid foundation
of trust on both sides. It is a partnership: the
board needs to be supportive of and a resource
to the CIO and, at the same time, hold the CIO
accountable.
Accept And Plan For The
Eventuality That We Are
Wrong
External Sources of Liquidity. While most CIOs
focus on the returns that alternative investments can provide, they fail to understand that
cash management becomes materially more
complicated when investing in them. It requires
a dedicated effort to evaluate and monitor our
counterparties and credit risk from an operational and total portfolio perspective.
What does this mean for investors? Our thinking and planning must be dominated by the
possibility of being wrong (about a manager,
a market, or a trade) as well as the consequences (cash losses, lagging performance in
a rebound, or a sullied reputation). Investors,
if they deal with this at all, use a probabilityweighted approach under which they can be
wrong simultaneously on both the probability and the severity of portfolio traumas. For
investors in the Manhattan Fund, Long-Term
Capital Management (LTCM), Amaranth, Bear
Stearns, and Bernard Madoff, the consequences
of being wrong mattered more than the probability assessments.
It is a best practice to diversify our borrowings
across a number of counterparties, maturity
schedules, and borrowing types when dealing
with external lenders. Not being diligent enough
in this department can come back to bite us. A
number of institutional investors found this out
PORTFOLIO CONSTRUCTION
“
A
s in a good
marriage, the CIO needs
to communicate his or her
philosophy and overcome
differences with the
investment committee.
Peter Bernstein outlines two important lessons about risk in his book Against the Gods.
First, the appearance of predictability is almost
always an illusion; we don’t know what is
going to happen, ever. Second, consequences
matter more than probabilities.
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”
—Alice Handy
2009
19
Best Practices In Alternative Investments:
the Principles (cont.)
Consistent ongoing monitoring of our managers
includes periodic updating of the due diligence
questionnaire with attention to any personnel
changes and/or reporting issues, along with
regular contact in order to build good lines of
communication.
T
“
he appearance
of predictability is almost
always an illusion.
”
The best practice is to understand and consistently monitor our managers, how they trade,
and the possible layering of risk that is taking
place. We can best protect ourselves from times
when we are wrong if we:
1. Diversify fundamentally across strategies,
asset classes, and geographies;
2. Have an appropriate number of uncorrelated managers; and
3. Maintain sufficient liquidity to give us
enough flexibility to make the adjustments
as they become necessary.
Conclusion
Many of the principles may seem fairly selfevident, and in many ways they are. They all
offer benefits to investors. However, applying
all of them consistently is the real challenge.
Short cuts that should be avoided abound in
each case: filling buckets with average managers or chasing returns; relying solely on statistics
to “optimize” the portfolio; letting day-to-day
portfolio management get in the way of thinking about how we could be wrong; ignoring
the needs of the board; assuming that current
liquidity will last forever; failing to engage our
managers in a deep dialogue; and following in
the footsteps of other investors.
The first step is to be honest about the needs and
the capabilities of our institution. Is an aboveaverage return required to meet our goals? Do
we have the staff resources and board-level
buy-in to pursue a complicated and occasionally
unconventional approach? The purpose of this
paper is to present some of the rationales being
used by sophisticated investors in alternative
investments.
T
“
he essence of risk is that we don’t know what’s going to happen. People act
like they really know what’s going to happen. We really don’t know what the future will
be. You must be alert to changes in the environment and continuously test the Policy
Portfolio’s assumptions.
20
2009
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”
—Peter Bernstein
BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Chapter 2 – Putting It All Together: The
Policy Portfolio
“To know, is to know that you know nothing.
That is the meaning of true knowledge.”
—Confucius
This chapter will introduce what, for many
investors, may be a new way to think about
portfolio construction. It will start with basic
precepts, discuss common tools for asset allocation and some of their weaknesses, especially
with respect to alternative investments, and
then discuss the emerging practice of grouping
assets by their economic role in the portfolio.
The Investment Policy
Statement
The investment process begins with the
Investment Policy Statement. This covers the
purpose or beneficiary of the portfolio spending, investment goals, and the Policy Portfolio.
It also sets the range of investment alternatives,
permitted vehicles, and constraints that govern
the implementation of the actual portfolio.
The purpose of the investment portfolio should
be foremost—the investment portfolio is the
means to an end unto itself. As fiduciaries we
should remember we serve the goal of the sponsoring institution or the individual beneficiaries.
An Investment Policy Statement spells out the
objectives of the investment process. The return
objectives and risk target must satisfy the obligations or purpose while not incurring undue
risk of loss or failure to meet current or future
needs (“short-fall risk.”) We must assume risk
in order to get any reward. Unfortunately, many
fiduciaries start with rewards (the returns) and
then move on to the resulting risks. This is
backwards. The real question is: Can we afford
these risks? Are we adequately compensated
for them?
PORTFOLIO CONSTRUCTION
We should consider whether an above-average
return is really necessary or realistic to accomplish our mission. We may prefer a more
certain average return that accomplishes the
mission because above-average returns almost
always entail above-average risks.
D
“
on’t ask ‘who is
The Policy Portfolio
An institution’s Policy Portfolio is the clearest
direct expression of an institution’s risk tolerances and return objectives; it is a “passive”
benchmark against which the achievement of
the objectives of the investment portfolio will
be measured. A Policy Portfolio is the sum of
all qualitative and quantitative views on risk,
liquidity, and funding needs. It communicates
how the institution will allocate among asset
classes and/or investment strategies to meet its
investment objectives. Changes to the Policy
Portfolio are infrequent and minor. A Policy
Portfolio can also serve as a performance measure of the CIO and team, although this should
not be the only measure.
winning?’ but rather ‘are we
doing what really matters
to us?’
”
—Charley Ellis
We should remember that, in setting a Policy
Portfolio, we should consider the capabilities
of our institution. Harvard and other large
endowments have dozens of talented, wellpaid professionals. Most institutions have but
a few staff members and even those may carry
additional responsibilities. The Policy Portfolio
should be appropriate to our specific institution
in order to be sustainable over the long run.
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21
Chapter 2 – Putting It All Together: The Old
School
Existing Best Practices: The
Old School
The most common tools used today to develop
Policy Portfolios are computer models:
1.
2.
3.
O
“
ptimizers are no
better than the assumptions
that are used.
”
A
“
ll models take
‘free lunch’ in investing—
diversification. The lower the
correlation, the greater the
22
All models take advantage of what David
Swensen calls the one “free lunch” in investing—
diversification. If there is less than a one-to-one
correlation between the volatilities of any two
assets, then their combined volatility is lower
than the weighted average of their volatilities,
and with rebalancing, their aggregate return
can be slightly higher than the weighted average
of their returns. The lower the correlation, the
greater the diversification benefits.
Optimizers are models used for optimization.
Some of the models use thousands of Monte
Carlo simulations to find the “most efficient”
asset allocation. Optimizers, however, have
limitations:
advantage of the one
diversification benefits.
Mean/variance optimization,
Multi-factor models, and
Asset/liability studies.
”
2009
Assumptions. Models are no better than the
assumptions that are used. We must recognize
that each assumption is the average depth of
a river. Returns, volatility, and correlations
change drastically in different economic climates. Many investors misuse their model by
inputting only a single set of assumptions that
they think is best. No one can come close to
getting the assumptions right. We should run
numerous iterations of the model using a wide
range of reasonable assumptions. Our goal
should be an asset allocation that holds up well
under the range of assumptions, not an allocation that is best under any single set.
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Illiquid Assets. Models see historical returns
on illiquid assets as low volatility and tend to
over-allocate to those assets. Illiquid investments rarely trade and prices can become stale.
The use of appraisals, mark-to-model, and other
pricing methods “smooth” returns with their
reliance on infrequent trades or nonmarket-generated valuations. Liquid proxies are available
for many illiquid securities, and we should use
an appropriate haircut for their illiquidity.
The Bell-Shaped Curve. Mean/variance optimizers are built on the assumption that volatility
always follows a bell-shaped curve, whereas we
know that tails of the curve—especially on the
downside—are much flatter and more dangerous. Over-reliance on the normal distribution
has proved too simplistic, leaving investors
unprepared for times like 2008.
Staying Power. Risk is generally expressed as
volatility, but this ignores our staying power.
Collecting the long-term equity risk premium
can sometimes require waiting 15, 20, or 25
years. Can our sponsor sit while it loses 75%80% as we rebalance into a declining equity
market?
Investment Availability. Models assume investments can be made and maintained at the Policy
Portfolio level. This can be difficult, or even
impossible to do, if we follow the Best Practice
of investing only with the highest quality alternative managers.
BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Chapter 2 – Putting It All Together: The New
School
Recent Best Practices: The
New School
We spend a lot of energy attempting to develop
an optimal asset allocation. Adjusting for the
uncertainty of our underlying assumptions,
there are many portfolios, in a statistical sense,
which might meet our objectives.11 We must
remember that risk changes over time. One
dollar of equities at 30% volatility has twice
the impact of one dollar at the historical average of 15%. We go through periods when risk
appears to be low and others when risk is high.
A constant dollar allocation means we are getting a changing risk allocation.
In 2003, Peter Bernstein questioned whether
Policy Portfolios were obsolete. The rigidity
with which many investors have applied Policy
Portfolios, and our over-reliance on allocation
tools, have caused a lot of pain. A more opportunistic approach seems warranted.
Sophisticated investors are increasingly adapting traditional multi-factor approaches to focus
on how different assets behave in terms of risk
and returns under different economic scenarios.
In building portfolios, investors should think
about the basic economic drivers in which we
invest and use three fundamental economic
groupings:
• Growth
• Inflation
• Depression
As time marches on, environments and relationships change. True diversification is a moving
target. It disappears when markets get bad, when
underlying fundamentals impact all traditional
asset classes the same way. Take, for example,
public equity, private equity, and U.S. sub-prime
mortgage-backed securities. Correlations for the
10-year interval prior to 2007 appeared to offer
useful diversification. In 2008, however, each
group was impacted by increased leverage and
banks’ interrupted ability to lend. In a crisis all
correlations go to one.
“
R
ather than sitting
with a rigid asset allocation,
you need more flexibility and
a willingness to change in
the short run. This implies
market timing. These are two
dirty words because it’s so
hard to do and few can do it
well.
”
—Peter Bernstein
11
Vijay K. Chopra and William T. Ziemba,
1993. “The Effect of Errors in Means,
Variances and Covariances on Optimal
Portfolio Choices,” The Journal of
Portfolio Management, Vol. 19, No. 6
(Winter).
PORTFOLIO CONSTRUCTION
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23
Chapter 2 – Putting It All Together: The
Economic Groupings
Table 1:
Economic Environments And Their Impact On Asset Prices
Prices
T
“
Disinflation
Inflation
Growth
[Falling prices,
growing economy]
(++) Public Equities
(++) Private Equity
(+) Credit
(+) Real Estate
(+) Bonds
(?) Commodities
(-) Bills
[Rising prices,
growing economy]
(++) Commodities
(++) Real Estate
(?) Public Equities
(?) Private Equities
(?) Credit
(-) Bills
(--) Bonds
Contraction
[Falling prices,
shrinking economy]
(++) Bonds
(++) Bills
(-) Public Equities
(-) Private Equities
(-) Credit
(--) Commodities
[Rising prices,
shrinking economy]
(++) Bills
(+) Commodities
(--) Public Equities
(--) Private Equities
(--) Bonds
hree groups of
drivers used by some
leading investors are
growth, inflation, and
deflation.
Real
Economy
(Volumes)
”
Deflationary
Depression
[Falling prices,
contracting economy]
(+) Bills
(+) Bonds
(+/-) Cash
Inflationary
Depression
[Rising prices,
contracting economy]
(+) Inflation-linked Securities
(TIPS)
(+) Gold
Source: Bridgewater
Economic Environments And
Their Impact On Asset Prices
The table above illustrates that each asset
has a particular season in which it blooms.
There is no one asset for all seasons. Inflation
drives nominal longer-term interest rates. High
growth rates and accelerating inflation hurt
bonds. Commodities benefit from inflation
24
2009
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and high economic growth. Real estate profits
from economic growth and falling inflation.
Inflation can help equities in terms of inventory gains and nominal price increases. But it
can hurt in terms of the rising cost of labor,
raw materials, and a higher discount rate on
future profits. Some investors believe equity
valuations may be at their best when inflation
BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Chapter 2 – Putting It All Together: The
Economic Groupings (cont.)
is about 2%. Price changes above or below that
level may hurt equities.
Most asset allocation exercises tend to mine
historical data with a heavy reliance on the past
25 years, or less in the case of alternatives. This
means that most programs are based on the
analysis of a single economic regime—disinflationary growth, the best economic environment
for risk assets. Extrapolating risk, return, and
correlations from the last 25 years is dangerously simplistic for any asset class. In today’s
world we should consider which era might
have the most predictive value for a particular
asset class. Ultimately, it can be exposure to
the underlying economic fundamentals and
risk factors that matters. If two main economic
dimensions are price and volume, then there
are four possible normal environments and two
terrible ones. The four normal environments
are the result of blending accelerating or decelerating inflation with a growing or contracting
real economy. They are disinflationary growth,
inflationary growth, disinflationary contraction,
and inflationary contraction. Two terrible ones
are inflationary and deflationary depressions.
Growth
Investing in a growth economic climate is done
mainly through corporate equity-oriented securities, both public and private. These include:
• Long-only public equities;
• Directional corporate security-focused
hedge fund styles, such as directional
equity, hedged equity, and certain
direct (or asset-based) lending;
• Venture capital; and
• Private equity investments driven by
operational turnaround or by financial
engineering.
E
“
xtrapolating risk,
return, and correlations
from the last 25 years is
dangerously simplistic for
The magnitude of the equity risk premium (historically more than 3% per year12 over bonds)
makes it the dominant allocation and driver
of most institutional portfolios. It is the only
scalable way for investors to reach their return
goals. The problem with growth is that for
something so vital, it is both too well and too
little understood.
any asset class.
”
There’s a difference between normal contractions and terrible ones. In normal environments,
monetary authorities have tools to limit the
downside. In a depression, authorities lose control, and massive de-leveraging results in wealth
destruction. If it is deflationary, we preserve real
wealth only by investing in government bills,
notes, and bonds. If it’s inflationary, we preserve
real wealth through inflation-protected bonds
and commodities.
12
PORTFOLIO CONSTRUCTION
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Over all 20-year intervals since 1961, the
S&P 500 has averaged 3.3% higher return
than long-term U.S. corporate bonds, ranging from 0% (the latest 20 years) to 7%
(1979-1998).
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25
Chapter 2 – Putting It All Together: The
Economic Groupings (cont.)
T
“
here is a wide
variety of securities and
strategies available to
combat inflation.
”
nly two assets
have proven to protect an
investor during deflation:
cash equivalents and
Declining inflation, if moderate, can provide
a positive climate for growth and also one in
which bonds can provide good returns.
A different economic dynamic takes hold when
the overall financial system has too much leverage and moves to reduce it, and interest rates
fall toward zero, as happened in 2002 and
2008—periods of asset deflation. The effect of
leverage is symmetrical: just as leverage can
boost returns of appreciating equity-oriented
assets, it magnifies the losses on those same
assets when they fall in value. These deflationary events can cause equities to plunge, as we
witnessed starting in October 2007.
Only two assets have proven to protect an
investor during deflation: cash equivalents and
longer-term government securities. Hedging
against deflation and financial panic can be
done cheaply with U.S. bonds. A simple longduration Treasury portfolio may be optimal.
In addition, many illiquid inflation-sensitive
investments exist. Real estate values historically
track building replacement costs. Energy partnerships fund the exploration and production
of oil and gas wells. Timber prices have, with
considerable volatility, more than exceeded
inflation.
longer-term government
26
Deflation
Inflation hurts portfolios in two ways. First,
there’s the loss of purchasing power. Even a low
2% annual inflation rate leads to a nearly 19%
drop in real value in 10 years. It drops by more
than one-third in 20 years. Second, inflation is a
double-edged sword for equities. It helps when
companies can book gains on their inventories
but hurts when labor and input costs accelerate
and future profits hold less value today due to
higher discount rates. The combination of mild
but stable inflation strikes the best balance.
Rapid inflation and deflation can both lead to
lower stock values.
There is a wide variety of securities and strategies available to combat inflation. Although
TIPS were not issued in the U.S. until 1997
and subsequent periods of rapid acceleration
in interest rates have been few and brief, there
is evidence that inflation-protected bonds can
provide direct protection. Commodity investments have been good hedges against inflation
but also have some correlation with growth
investments.
O
“
securities.
Inflation
”
2009
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BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Chapter 2 – Putting It All Together: The
Strategy Combinations
Table 2:
Investment Strategies Under Different Economic Scenarios
liquidity
Most
growth
inflation
deflation
Public Equities
Equities (Long-only)
Natural Resources
Commodity Indexes
Gold
Cash
Credit
Mortgage Debt
Investment Grade
Municipal Debt
High Yield
Inflation-linked
Securities
Government Debt
Federal Debt
(Long-only)
Hedge Funds
Hedged Equity
Credit and High Yield
Direct Lending
Activist
Hedge Funds
Commodity Traders
skill-based
diversifiers
W
“
hat is
seldom acknowledged is that
getting the environment right
matters enormously.
Hedge Funds
Short-biased Equity
and Credit
”
Hedge Funds
Global Macro
Relative Value
Event-Driven
Multi-Strategy
Real Estate
Core
Value-Added
Opportunistic
Distressed Credit
Natural Resources
Energy Partnerships
Timberland
Agricultural Land
Private Equity
Leveraged Buyout
Venture Capital
Least
Infrastructure
Transportation
Power Generation
Pipelines
Private Equity
Operational
Turnaround
Source: Greenwich Roundtable
What is seldom acknowledged is that getting
the environment right matters enormously. If
the historical equity risk premium were 5%
with volatility 15%, that means that, after
20 years, an investor would have 170% more
wealth investing in equities than bonds with
a 95% probability. If the premium were only
2%, then investors have to wait 200 years
PORTFOLIO CONSTRUCTION
to get to the same 95% chance of success.
If it is 0%, investors would have 50/50
odds of stocks beating bonds forever!13 Being
invested in risky assets during a deflationary
depression and being long fixed-income during inflationary expansions are both recipes
for destroying wealth.
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13
Robert D. Arnott, 2004. CFA Institute
Conference Proceedings, “Points of
Inflection: New Directions for Portfolio
Management” (July): 39-52.
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27
Chapter 2 – Putting It All Together: The
Economic Groupings (cont.)
O
“
verlapping all
the economic groupings is
active management—which
Establishing an appropriate asset allocation is
one of our most important exercises. But we
want to avoid the slavish adherence to a singlepoint allocation. We should be aware of the
limitations of our tools and maintain some flexibility as we allocate actual assets. The world is
generally in one of two states. One is a normal
state where recessions are possible, with normal
return, risk, and correlation assumptions. The
other is a depression state, where a different
set of assumptions prevails. We could profit by
modeling both.
taps human creativity,
Skill-Based Diversifiers
intuition, and insight.
”
Overlapping all the economic groupings is
active management—which taps human creativity, intuition, and insight. Most asset classes are
still dominated by the beta of those asset classes.
Alternatives, such as hedge funds and private
capital, are far more skill based. As discussed in
Chapter 1, if we are invested with top-tier partnerships and managers, the returns justify the
effort and the allocation—alpha can be earned.
If we cannot access these top-tier managers, our
selections are often wealth-destroying.
Whether due to skill, short selling, leverage, or
the use of derivatives, alternative investment
managers’ returns conflict with our assumptions
about efficient markets and bell-shaped curves.
Good strategies and managers should demonstrate more upside than downside volatility,
compressing the left tail.
14
This is especially true in today’s environment where hedge funds defied expectations of protecting capital and fell 20%
in 2008. Numerous alleged frauds—i.e.,
Petters Group and Bernard Madoff—
shocked investors. Private equity saw its
leveraged finance model hobble investors
with many likely insolvent investments.
Profit distributions dried up and capital
calls unexpectedly taxed investors’ capabilities. Real estate is in its cycle of huge
losses, and natural resources offered little
diversification.
28
2009
Alternative investment managers may add more
risk-adjusted value than traditional managers
but not without a price. There are higher fees,
possibly unorthodox investment approaches,
dramatically reduced liquidity, and considerable
public misunderstanding about the industry and
the accompanying headline risk and shifting
strategies.14 The board and investment team
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need to take these issues into account when
designing an investment program.
Making The Actual Investments
Appropriately sizing the allocations to economic
groupings is the most important decision in
building our Policy Portfolio. Asset class diversification and manager selection should be secondary in importance. Maintaining a consistent
risk exposure over time dictates that allocations
among assets be flexible.
Hiring active managers, especially in alternative programs, implies confidence in our ability
to select managers that add value above their
benchmarks and fees. It also means a willingness to spend the money and time necessary
to source, perform due diligence, monitor, and
manage them. The goal is positive after-fee and
risk-adjusted alpha for the aggregate portfolio.
We should expect to take years to build a highquality and diversified portfolio. Our goal is to
hire only the best managers, even if this means
passing on many managers for a few years.
There was a mad rush into venture capital in
1998, 1999, and early 2000. Even mediocre
partnerships and managers got funded as investors were eager to fill this bucket in their Policy
Portfolio. In many cases, results have been very
disappointing.
As we add managers to our alternative programs, we must decide on how much to allocate
to each manager in a particular strategy or asset
class depending on our assessment of risk and
our confidence in our assessment of the manager’s ability to add value.
Assuming their assessment of quality is roughly
the same, some investors begin their allocation
by equal-weighting their managers. We should
BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Chapter 2 – Putting It All Together: The
Economic Groupings (cont.)
be skeptical about being able to predict higher
or lower information ratios with any degree of
precision. On the other hand, if the volatility
or leverage among our managers in the same
strategy differs radically, we might half-weight
our more volatile managers.
Before planning to rebalance our alternative
programs, we should remember that we might
not be able to make redemptions or have
capital called when we want. Finally, no matter how great we think a particular manager
is, we should ask ourselves this question: Are
we are really confident enough to justify any
allocation greater than 5% of our portfolio?
We should never risk more money than we are
willing to lose.
Rebalancing
The purpose of the asset allocation exercise is to
produce a liquid, passive portfolio that, within
risk constraints, provides the best expected
rate of return. The resulting Policy Portfolio
may have precise allocations or, so as to allow
greater flexibility to manage risk and liquidity,
might establish acceptable bands around those
allocations.
A key difference of opinion exists between “markettiming” and rebalancing the portfolio. Market
timers buy because they believe an asset class
appears undervalued. Those who have a discipline of rebalancing to their Policy Portfolios do
so for two reasons. First, they don’t feel capable
of identifying undervalued asset classes. Second,
they believe that an outperforming asset class
has, on average, become more expensive than
the one they are rebalancing into.
we reverse the move also in a timely manner.
Many investors find that hard to do.
Rebalancing or market timing is more complicated with alternative investments because
of limitations on their liquidity and changing
allocations within funds.
A
“
ssuming their
assessment of quality
Summary
The fact is, when it comes to asset allocation,
there is no single answer. Principles are needed
rather than rules. Sophisticated investors are
always anticipating what can go wrong, trying
to assess the downside and unintended consequences, and making sure that they minimize
opportunity costs. The sophisticated investor
is alert to changes in the broad economic environment to anticipate potential shifts between
asset groups.
is roughly the same,
some investors begin
their allocation by
equal-weighting their
managers.
”
Of course, the only thing that counts is the
future. If we are to adapt this approach, how
are we to know:
• What part of the economic cycle we
are moving into and for how long?
• How much of that information is
already reflected in today’s asset
prices?
That is the challenge all investors face. We can
tackle it with our experience, our continuing
research, and our diligent analysis of all that is
going on in the world.
Market timing, of course, is a two-decision
decision. If we move from stocks to cash in a
timely manner, we will lose the benefit unless
PORTFOLIO CONSTRUCTION
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29
Chapter 2 – Putting It All Together: The
Economic Groupings (cont.)
Table 3:
Allocation Of Some Prominent Institutional Investors Using
Best Practices
S
“
sum of allocation
Asset Group
ophisticated
CalPERS
Ford Foundation
Harvard
Yale
Distribution
investors are always
Growth
anticipating what can go
wrong ... they are alert
Domestic Equities
23.0%
37.5%
11.8%
11.0%
International Equities
19.2%
26.5%
11.9%
14.1%
Emerging Markets
Equity
10.0%
High Yield
2.0%
Private Equity
to changes in the broad
Growth Total
Deflation
economic environment to
anticipate potential shifts
between asset groups.
GR Label
institution
”
11.6%
12.0%
18.7%
56.2%
75.6%
47.8%
43.8%
Fixed Income
4.0%
Domestic Bonds
19.8%
20.0%
1.3%
International Bonds
2.2%
0.9%
3.1%
Cash & Equivalents
8.7%
3.5%
-5.3%
1.9%
30.7%
24.4%
2.0%
5.9%
Deflation Total
Inflation
14.0%
Real Assets
2.0%
27.1%
Liquid Commodities
9.8%
Timber/Agricultural
Land
6.1%
Real Estate
11.2%
8.0%
Inflation-indexed
Bonds
Inflation Total
Skill
7.1%
13.2%
Absolute Return
Skill Total
30.9%
27.1%
19.3%
23.3%
19.3%
23.3%
Source: Published annual reports. Asset class definitions vary by institutions. Unless an institution specifically carves out absolute
return, there is no way of knowing the allocation to “skill.”
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BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Chapter 3 – Constructing A Successful
Hedge Fund Portfolio
“The only perfect hedge is in an English
garden.”
—Anonymous
Contrary to investors’ experience in 2002,
many hedge funds failed to protect capital in
the severe climate of 2008. Disappointed investors expecting positive returns in a negative
market environment redeemed or attempted to
redeem substantial amounts from hedge funds.
The long-term viability of the “hedge fund
model” is being actively questioned. Prior to
the Great Credit Crisis of 2007-2008, investors
willingly accepted expanded fees and lock-ups
for the notion of absolute returns. This trend
may reverse. As many investors redeem, the
balance of power may shift back in the direction of the investors.
The hedge fund business model is not broken
but leverage will be significantly lower for the
foreseeable future, driven by availability, cost,
and risk management considerations. Hedge
funds will shrink not only in numbers but also
as a percentage of the value of security markets.
This should lead to greater inefficiencies in the
markets, enhanced flexibility, and more profitable investments for those who continue as
investors and survive as managers.
“Opportunistic” or “directional” hedge funds
are strategies that owe their returns primarily
to the direction of the markets; hedged equity,
net-short funds, trend following, and commodity traders are examples. Relative value
strategies are more dependent on some form of
arbitrage and try to minimize beta; examples
would be equity market neutral and fixedincome arbitrage approaches. These strategies
aim for a low beta to equity and credit markets
depending on the strategy. In theory, nondirectional implies being equally long and short
to isolate the effects of security selection from
market returns. However, if gross exposures
of longs and shorts greatly exceed 100%, the
leverage applied to small inefficiencies can be
quite high.
H
“
edge funds
are mostly traditional
assets managed in nontraditional ways.
”
Not all markets have developed equally in
regard to the ability to short-sell assets. Also,
not all assets are amenable to a given trading
style. For example, event trading applies to corporate securities and is not relevant to foreign
exchange or commodities; some event-driven
managers are very opportunistic and often
have directional market exposure; others are
pure relative value traders. Hedge funds can
be reduced to the dimensions of asset class and
trading style, with a sub-classification of geography when relevant.
Hedge Fund Styles
Hedge funds are mostly traditional assets managed in non-traditional ways. A key advantage
of hedge funds is their enhanced flexibility relative to traditional strategies. There are many
ways to classify hedge funds, each with its own
particular nuances. These are often categorized
as being either “market directional” or “relative value” and grouped using both the traditional dimensions of asset class, and geography,
plus strategy.
PORTFOLIO CONSTRUCTION
Directional Styles usually involve being both
long and short securities, but with the overall
net exposure being generally greater than 50%.
Returns are strongly dependent on the direction
of the underlying market traded. The performance of equity markets constitutes a material
portion of the ultimate returns (i.e., stock index
movements coupled with security selection
alpha). Returns can be quite high with this
approach, especially with high net exposures
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31
Chapter 3 – Constructing A Successful
Hedge Fund Portfolio (cont.)
to volatile markets. But this comes with higher
volatility and “fat tails.”15
V
“
olatility is awful for
our psyches but good for
trading opportunities.
”
—Todd Petzel
T
“
ail risk happens when
market crises occur and
liquidity disappears.
”
15
Events considered well outside of a normal range arising from both the underlying markets’ behavior and the long/short
aspect of the portfolios and the gross
exposure/leverage being used.
16
The layer in a company’s capital structure that is most likely to receive equity
in the reorganized company in a Chapter
11 plan.
17
London Interbank Offered Rate and the
Overnight Index Swap Rate.
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2009
Directional strategies include:
• Directional equity (and sub-strategies)
and short-biased equities;
• Directional credit (and sub-strategies)
and short-biased credit;
• Global macro trading in equity, fixedincome, commodity, and currency
markets; and
• Commodity traders.
Event-Driven Styles involve trading around corporate events—changes in capital structure,
mergers and acquisitions, bankruptcies, and
reorganizations. These styles profit from a combination of factors:
• Correctly anticipating the outcome
(such as the actual closing of a merger
and its effective date),
• Being positioned in an appropriate
security (either a fulcrum security16
in a reorganization or the security
issued to facilitate a restructuring or
refinancing), or
• Influencing the outcome through
shareholder activism in equities or
controlling the creditor committee in
bankruptcies.
Because events either happen or they don’t, little
is earned ahead of the event. Most or all of the
value is realized when the event occurs. Many
event-driven managers trade a combination of
the strategies.
Relative Value Styles, also called arbitrage,
involve being long and short securities that
tend to move together in roughly equal proportion. Profits or losses are earned almost
entirely through security selection. A typical
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trade involves some form of mean reversion
either in a statistical sense such as the spread
between Libor-OIS17 or fundamental reasons
(i.e., cheaply valued stocks will tend to rise
relative to more expensively valued ones). The
reversion of spreads between longs and shorts of
related securities tends to provide relatively low
returns with only modest volatility. Therefore,
some managers employ leverage much more
heavily, with gross exposures as high as 600%
in equities and 1,000% in fixed income.
This combination of mean reversion and leverage earns steady returns in good times. In bad
times, especially in de-leveraging, it can suffer
large losses. Historically, leveraged fixed-income
strategies have been at the root of most hedge
fund blow-ups. But some equity market neutral
managers, especially quantitative ones, suffered
losses of 20%-40% in August 2007 when 10x12x leveraged balance sheets magnified losses of
3%-4%. Tail risk happens when market crises
occur and liquidity disappears.
Multi-Strategy Managers: These blend some or
all strategies across several asset classes. Most
large firms, especially the largest multibillion
dollar managers, started with a single specialty.
They then evolved into multi-strategy blends,
modifying the weighting of their various strategies over time because they were able to bring
on talented traders in other specialties, or they
believed the blend is more efficient than a single
approach. When reviewing prior returns of
multi-strategy managers, we need to take into
account the particular strategies the managers
were using at that time.
Managed Futures: This is a style that stands
alone, a name given to investments in commodity
futures, both physical and financial futures. They
are managed by commodity trading advisers
BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Chapter 3 – Constructing A Successful
Hedge Fund Portfolio (cont.)
(CTAs) and regulated in the United States by the
Commodity Futures Trading Commission. Other
hedge fund strategies, such as global macro, also
trade in futures along with many other securities.
Managed futures, however, denotes strategies
devoted exclusively to futures.
Many of those who trade commodity futures
are hedgers, business people who are buying insurance. The farmer sells corn futures
because he can’t afford the risk of fluctuating
corn prices at harvest time. The importer buys
futures on the Japanese yen because he can’t
afford unpredictable fluctuations in his cost of
goods sold. Hedgers are not always in equilibrium. At times, more need to buy than sell, or
vice versa.
Liquidity to commodity markets is provided
by speculators, which include CTAs. The
better of them are among the more quantitative academics in the investment world. They
absorb the volatility in most commodity markets. They minimize their volatility by investing in a wide range of commodities with little
or no correlation to one another, and they
rationally expect to make a long-term profit
on their investments.
CTAs rely primarily on price information but
differ from one another dramatically in their
trading styles. The majority pursue some form
of trend following, while other styles include
macro-fundamental, counter trend, relative
value, volatility arbitrage, and pattern recognition. Most CTAs are quantitative investors,
with all their trades triggered by computer,
although some CTAs do discretionary trading.
Futures trading is characterized by high turnover. Perhaps half of all trades are for three
days or less, many for less than a day. A few are
for 30 days or longer.
PORTFOLIO CONSTRUCTION
Funds of managed futures use multiple CTA
strategies, either within their own firm or via
a fund of funds. Individual CTA strategies are
often quite volatile, but funds mitigate that
volatility dramatically by assembling a portfolio of CTA strategies that have low correlations
with one another.
One advantage to CTAs is the low correlation
of managed futures strategies with stock and
bond markets and other hedge funds.
P
“
eople have a
tendency to miscalculate
probabilities. Their
decision-making framework
does not include negative
outcomes.
The Beta In Hedge Funds
”
—Nassim Taleb
Hedge funds are typically thought of as sources
of alpha but in reality have a strong link to
betas. Since we can quite easily and inexpensively purchase beta through an index, we
seek active managers who can add alpha.
It’s important to understand how much beta
may be imbedded in our hedge funds. Hedge
funds known to have high beta include naïve
automatic implementations of strategies such
as convertible arbitrage or merger and acquisition (M&A) arbitrage. It is important that we
recognize this linkage and adjust our portfolio
allocations accordingly.
Based on the Tremont hedge fund indices,
Bridgewater Associates calculated that between
July 2001 and June 2008, equity long/short
hedge funds—which account for nearly onethird of all hedge funds—had an average riskadjusted correlation of 0.81 with the stock
market. Bridgewater also calculated that eventdriven hedge funds had a 0.90 risk-adjusted
correlation with high-yield bonds and a simplistic implementation of M&A arbitrage.
Most hedge funds had materially negative
returns in 2008 because they had more exposure to beta than alpha, especially equity betas
that perform poorly in bad economic times.
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Chapter 3 – Constructing A Successful
Hedge Fund Portfolio (cont.)
Moreover, their alpha typically had systematic
biases toward performing better in good times
than in bad times.
B
“
ecause each hedge
fund is different, we must
assess the beta of each hedge
fund individually.
”
H
“
ow much of a
hedge fund’s alpha is simply
the result of investing in
Bridgewater calculated that systematic risks
accounted for 95% of the returns on all hedge
funds for the third quarter of 2008, composed
as follows:
• 50% developed, market equities
• 23% corporate high yield
• 6% emerging markets debt
• 4% mortgage-backed securities
• 4% market trending
• 4% emerging markets equities
• 3% yields
• 1% short volatility
That, of course, was the average for all hedge
funds. Because each hedge fund is different, we
must assess the beta of each hedge fund individually. We can do that by calculating how a fund’s
historical returns and that of its relevant betas
change together over as many years as possible
and adjusting these links to make them volatility
equivalent. We should further adjust these covariances based on our qualitative assessment of
the predictive value of that hedge fund’s historical returns. This is not an easy exercise.
securities that are less
To better understand 2008, especially the fourth
quarter following Lehman Brothers’ demise, we
must realize how quickly credit evaporated from
the global markets. That, along with redemptions, forced hedge funds to slash their leverage
by selling into an illiquid market. This accelerated market declines. This disaster affected most
investment strategies and raised another issue:
Is illiquidity another form of embedded beta?
How much of a hedge fund’s alpha is simply
the result of investing in securities that are less
liquid? That should be a part of our analysis of
every hedge fund we consider.
liquid?
”
34
2009
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Ideally, we would prefer hedge funds with large
alphas and low betas. If a hedge fund has an
attractively high alpha but also a reasonably
high beta, then we should take either of two
steps:
• If we can accept the betas, then adjust
the rest of our portfolio to reflect the
additional beta in our hedge fund.
• If we cannot accept the beta, then
we can hedge it out by changing the
portfolio weightings or, if that is not
feasible or desired, by selling futures
or swaps that are highly correlated to
that beta.
Hedging out the risks of less liquid securities,
however, is a bit harder to do.
What Have Hedge Funds
Produced?
Hedge funds’ combination of skill and unconstrained mandates aims for attractive returns
with low volatility of returns and low or
moderate correlations to market indices. On
average this has been true since the start of the
1990s, when reliable data first became available. Averages, however, conceal a wide variety
of features and outcomes of individual manager
and strategy results as well as variations over
time. It is important to note that most hedge
funds do not even have six-year track records.
There is considerable variation across and within strategies as well as across and within years.
There is considerable concern about the quality
and the quantity of the historical return of hedge
fund universes.
The first concern is the voluntary nature of
funds reporting their results to market indexers. This may lead to an upward survivorship
bias because poor-performing or liquidating
funds drop out of the results. This leaves only
BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Chapter 3 – Constructing A Successful
Hedge Fund Portfolio (cont.)
the “winners” to be counted. Andrew W. Lo
and others estimated that it could account for
1%-2% annually. The industry seems to experience roughly 10%-15% attrition per year.
Most funds fade away or close due to unspectacular performance rather than the much
publicized blow-ups or much-feared fraud.18
Considerable variations exist within the industry and across years, with certain strategies at
the epicenter of losses and closings in a given
year. One of the main incentives for a fund to
report its returns to a database is publicity and
attracting new investors. On the other hand,
top-flight managers have little incentive to
report results. Many are closed to new investors and often prefer that limited partners’
experiences be kept private.
Second, there is concern about the instruments
traded and their valuation. Hedge funds trade
many instruments that are either less liquid
or actually illiquid. These include bank debt,
distressed securities, control positions in public
equities, some structured derivatives, private
equity, or debt and direct loans. Pricing these
securities may not be as frequent, given their
illiquidity, and requires the use of many estimates. This can tend to smooth returns and
understate volatility. Cliff Asness of AQR first
discussed this possibility in 2001.19
Third, managers shift and add strategies over
time as opportunities and their abilities evolve.
Hence, track records for a given strategy are
hardly pure because they reflect managers’
adjustments over time. We should understand
these changes as we attempt to understand the
managers’ relative abilities in their original and
new approaches.
Despite these possible shortcomings, the quality
of hedge fund returns makes them compelling
PORTFOLIO CONSTRUCTION
investments. Of particular interest is the nature
of the returns, most notably their “asymmetry.”20 A “good” hedge fund’s process should
focus on hedging downside risk, either explicitly or implicitly. Many managers mitigate
the inherent susceptibility of event-driven and
relative value approaches to market crises
and illiquidity by “spending” some return
on insurance. Such insurance includes stock
index puts or credit protection. In hedging risk
implicitly, deep value strategies focus on buying securities with “margins of safety” at levels
enough below the securities’ intrinsic values.
In this way, should the manager be wrong or
markets go haywire, the fund will not suffer
large losses.
A
“
‘good’ hedge fund’s
process should focus on
hedging downside risk, either
explicitly or implicitly.
”
Another approach is to seek managers who
possess a positive volatility or gamma profile
either through trading style or instrument selection and trade construction. In the first case,
managed futures traders have historically performed well during market crises for a variety
of reasons. Second, some managers in other
strategies explicitly use long option positions
to help when market crises occur and volatility
and correlations both rise.
While individual funds can generate sharply
different results including negative returns,
a portfolio of hedge funds tends to possess a
more muted downside than traditional equity
indices. This positive “skew” is a source of
debate and is also dependent on the skill and
experience of the fund manager. However, the
drawdown experience of hedge funds versus
equities, fixed income, or a blend indicates that
they offered these highly attractive characteristics from 1990 through 2007, including an
interval of negative months for equities during
the early 1990s. This changed, of course, in
2008 when the average hedge fund was down
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18
Christopher Kundro, 2003. “Understanding and Mitigating Operational Risk
in Hedge Fund Investments: A Capco White
Paper,” New York: Capco Consulting.
19
Clifford Asness, Robert Krail, and John
Liew, 2001. “Do Hedge Funds Hedge?”
The Journal of Portfolio Management, Vol.
28, No. 1: pp. 6-19. Also, Clifford Asness,
2004. “Alpha, Beta, Schmalpha,” The 2004
IAFE Annual Conference, p. 15.
20
Alexander
M.
Ineichen,
2007.
Asymmetric Returns: The Future of Active
Asset Management, New York: John Wiley
& Sons.
2009
35
Chapter 3 – Constructing A Successful
Hedge Fund Portfolio (cont.)
some 20%. Even so, that was better than the
stock market or high-yield bonds.
Unfortunately, more money tends to flow into a
fund in good times and be withdrawn in times
of stress (when it is needed). This lends a “buy
high, sell low” aspect, which is characteristic of
the asset allocation decisions of many individual
and institutional investors.
W
“
hat separates
money makers from the
2.
merely good managers is
It is often said that past performance is no guarantee of future performance. The experience of
2008 proved that. The past gave few clues to the
pain suffered by asset classes and hedge funds
in 2008, which were many standard deviations
away from any prior norms.
the intangible quality of
good judgment.
”
Best Practices In Investing In
Hedge Funds
Selecting Investments
We all want to “collect quality” when investing in hedge funds. Translating this into specific managers and allocations is easier said
than done. First, how do we determine and
access “quality?” What does it look like? Will
the manager take new investors, especially
in capacity-constrained strategies? Second, we
must investigate the managers and their claims.
Third, we must execute the actual investment—
negotiating and sizing it. Finally, once hired
and funded, we must stay on top of what the
manager is doing and take appropriate remedial
action if necessary.21
21
Practical guidance on all items except
the third is available from the Greenwich
Roundtable’s “Best Practices in Hedge
Fund Investing” series.
36
2009
These first two issues involve due diligence in
selecting managers, a topic covered in detail
in our three Best Practices in Hedge Fund Due
Diligence publications. There are a few general
principles worth emphasizing.
1. Finding and selecting quality partners is
akin to getting married, not dating. It is hard
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3.
work. It involves many ups-and-downs, but
ultimately, like all good things, the rewards
are well worth the effort. Keeping a longerterm perspective is important. Understanding
that the investment is a partnership (a twoway street), in both a legal form and in its
essence, is equally important. We should
strive to be a good partner and expect the
same of our manager.
Manager selection should not be done
lightly. Building a portfolio of hedge fund
managers is an involved process. It can be
done in-house but requires considerable
expertise and knowledge of specialized
trading strategies, a variety of financial
markets and instruments, investment and
business management operations, trade
execution and clearing, risk management,
and portfolio construction. Then there’s
the ability to properly check references.
Depending on the scale and abilities of our
organization, we may or may not seek the
expertise of advisers, consultants, or funds
of funds.
People trump strategy and process. The
basics of stock selection have been wellknown since Benjamin Graham codified
them. Singleness of purpose, the fortitude
to be in an “unpopular” investment, constancy of curiosity, and the willingness to
work hard are all requirements for success. What separates money makers from
the merely good managers is the intangible quality of good judgment: knowing
how and when to size their best ideas
appropriately; knowing when to change
their mind before they are proven wrong;
when to stay the course; knowing how to
keep the portfolio balanced so that losses
are manageable; and, above all, knowing
which ideas are worth pursuing and which
are fads that are meant to pass. Managers
BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Chapter 3 – Constructing A Successful
Hedge Fund Portfolio (cont.)
4.
characterized by the “five Hs”—honest,
honorable, hungry, hard-working, and
harmonious—are likely to perform better
than those lacking one or more of these
characteristics.
Remain skeptical. Investment management is a minefield filled with passing
fads, impractical theories, and agency
conflicts that have a sad track record of
enriching managers at the expense of their
clients. Never fall in love with an investment manager.
The capacity of any investment manager to
handle assets is finite. It can be augmented by
hiring additional skilled staff or by expanding
the program to new markets. Beyond this finite
level, risk-adjusted performance degrades. It is
in the clients’ best interest to keep assets below
that level.
In terms of practical tips, a few that were noted
in Best Practices in Hedge Fund Due Diligence
include:
• Finding good managers is hard work.
Take advantage of any network
(professional contacts, our boards,
alumni groups) that can provide
introductions.
• In times of turmoil, managers are more
likely to communicate proactively and
call investors than when times are
good. Take advantage of the long
horizon that being an institutional
investor allows you to have.
• When evaluating a manager, the
track record is likely to spark initial
interest. However, the focus of the due
diligence should be getting into the
managers’ heads and understanding
how they think. Beware of the
PORTFOLIO CONSTRUCTION
tendency to “buy high and sell low”
when selecting managers!
• Fees can occasionally be negotiable. The
size of institutional allocations and the
likely duration of the relationship act
as carrots. It’s preferable to structure
something that more directly aligns
a manager’s interests with our own.
The idea is not necessarily to reduce
the overall fee paid. Rather, to more
closely align the motivations of the
manager and investors. Negotiating
can be hard when other investors
insist that hedge funds offer a “mostfavored-nation” provision. However,
in the post-2008 world, negotiating
shifted in favor of investors.
• Selecting and performing due diligence
on a manager is just the first step. After
hiring, ongoing monitoring should be
a primary activity. While finding new
managers is exciting, we’re only at risk
with those we’ve funded. We should
spend our time accordingly.
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N
“
ever fall in
love with an investment
manager.
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”
37
Chapter 3 – Constructing A Successful
Hedge Fund Portfolio (cont.)
Sizing Positions
In sizing any position, there are three main
considerations:
• What is the manager’s expected riskreward trade-off?
• How do we expect it to behave relative
to everything else we are invested in?
• What is our confidence in these
estimates?
A
“
ssumptions for
returns, volatilities, and
correlations are highly
Whether we are allocating dollars or risk further
complicates this issue. A dollar in an unpredictable investment clearly has a greater impact and
risk profile than a dollar in a subdued one.
uncertain, especially for
hedge funds.
”
Hedge funds aim for the highest reward-risk
trade-off on the efficient frontier. Mean/variance models with Monte Carlo simulations randomly produce different outcomes for efficient
portfolios. But the assumptions for returns,
volatilities, and correlations on which they are
based are highly uncertain, especially for hedge
funds. Moreover, the long lock-ups and time
lag to modify positions limit the application of
quantitative models in managing a portfolio of
hedge funds.
Fat Tails (events outside the range of normal) And
Black Swans (extreme events that occur with great rarity)
Schizophrenia seemingly characterizes the behavior of securities markets. Prices reflect the relatively quick changes in perceived fundamentals. Many investors simplify these dynamics by using
a Gaussian (“normal”) distribution of price changes.
Yet, with some regularity, a seemingly reasonable idea is taken far beyond its logical conclusion.
People over-invest, returns are compressed, and eventually enormous quantities of leverage are
applied to maintain returns. This inevitably leads to a forced liquidation. Prices adjust far faster
and with far greater magnitude than “normal” statistics would suggest (until they go too far most
of the time).
In theory, many hedge fund strategies offer asymmetric return profiles. This can be good if the
approaches offer upside participation with limited downside as opposed to those that offer substantial downside in exchange for limited (but mostly steady) upside. Best Practices in Hedge
Fund Investing: Due Diligence for Fixed Income and Credit Strategies asked a key question: “Is
the strategy long or short volatility? Is the strategy long– or short–tail risk?” The answer provides
a useful summary of the impact of deleveraging events on hedge funds and a reason to plan for
the tails:
“As part of understanding a manager’s fundamental strategy as well as his ability to manage risk,
it is often helpful to think of a strategy using the concept of optionality. In other words, is the
strategy similar to owning (being long) an option or selling (being short) an option? Long volatility
strategies may cost something to hold (the option premium) but will pay nicely as either volatility
increases or the option becomes “in the money.” This is often compared to buying an insurance
policy. Short option strategies will pay the option seller, but will be costly if the inverse occurs,
much like an insurer who writes only one policy that is triggered. Optionality can arise implicitly
from the trading strategy employed or explicitly from being long or short options overall.”
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BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Chapter 3 – Constructing A Successful
Hedge Fund Portfolio (cont.)
Absent explicit style or strategy objectives, we
should also strive to balance different hedge
fund strategies. But the caveat is always “managers first, strategy second.” If we are only able
to find quality players in one style, we should
not allocate to sub-par managers in others just
to “fill a bucket.” Rather, it is particularly
important to be on the lookout for first-rate
managers in under-represented styles.
Forming A Portfolio Of
Hedge Funds
Hedge funds can provide a valuable part of an
institution’s overall portfolio. Once we have
assembled a group of hedge funds that we
qualitatively judge outstanding, we can evaluate each quantitatively through:
• Its aggregate long-term historical
return and volatility,
• Its built-in betas, and
• Cross-correlations of all the hedge
funds within our portfolio.
We can do this mainly with hedge funds that
have upwards of six years of monthly returns.
The longer the better, provided a fund’s strategy or management hasn’t changed materially
over that time. We should view such historical data over multiple intervals. Hedge funds
behave differently in different investment climates, such as equity bear markets or credit
crises. In short, we shouldn’t simply operate by
the numbers. We should look at what’s behind
the numbers and judge the predictive value of
each. This exercise can be even more fruitful if
you have position-level or risk transparency. In
today’s changed environment, it can be possible
to get this.
greatest diversification benefit to our portfolio.
To be truly market neutral means a near-zero
expected correlation with the stock market (our
portfolio’s greatest source of risk) and about
zero average correlation among the hedge funds
in the portfolio. If the correlation is actually
negative, that’s even better.
We may use such a portfolio in three ways:
1. As an additional component of our overall
fund. Most mean/variance portfolio optimizer models love an allocation that has
zero correlation with the stock market. Its
diversification benefit is an investor’s “one
free lunch.”
2. As a separate section of our overall fund,
one that has a near-zero correlation with
the stock market. Most mean/variance
optimizer models love a hedge fund portfolio like this. Its diversification benefit is
an investor’s “one free lunch.”
3. As portable alpha, combined with either
stock or bond index futures or swaps. The
volatility added to the overall portfolio by
hedge funds in portable alpha is very small
if, and only if, the hedge fund portfolio
has close to a zero correlation with the
underlying futures. The near-zero correlation is imperative.
w
“
e should strive
to balance different hedge
fund strategies. But the
caveat is always ‘managers
first, strategy second.’
”
A hedge fund portfolio will be most valuable
to our overall fund if the portfolio is truly
market neutral, because it will provide the
PORTFOLIO CONSTRUCTION
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39
Chapter 3 – Constructing A Successful
Hedge Fund Portfolio (cont.)
Building a market neutral portfolio of hedge
funds is a challenging assignment. It’s equally
difficult to maintain that market neutrality,
especially in dynamic markets as we weight, reweight, and rebalance our risks, managers, and
allocations. Witness the historic correlations of
various kinds of hedge funds from January 1991
to October 2008:
T
“
o be truly market
neutral means a near-zero
Correlation Correlations
to
to Other
MSCI World Hedge Funds
expected correlation with
the stock market (our
portfolio’s greatest source
of risk) and about zero
average correlation among
the hedge funds in the
portfolio.
Total Hedge Fund Index
Global Macro
Fixed-Income Arbitrage
Convertible Arbitrage
Long/Short Equity
Equity Market Neutral
Event-Driven
Emerging Markets
Dedicated Short Bias
Managed Futures
Multi-Strategy
.63
.17
.34
.37
.71
.37
.64
.45
-.70
-.33
.53
.57
.56
.61
.55
.31
.31
.71
.58
-.45
-.27
.60
Source: CSFB
”
Some of us also use top-tier hedge funds that
have higher correlations with equities as a
substitute for an active manager of equities or
some other asset class. This may be beneficial,
but not nearly as beneficial as a market neutral
portfolio of hedge funds with an equivalent
expected return.
Portable Alpha
22
Assuming (1) correlation is zero, (2) the
standard deviation of the index future (f)
is 15%, and (3) the standard deviation
of the portable alpha (p) is 6%, then the
combined standard deviation is:
(f2+p2)½ = (.152+.062)½ =
(.0225+.0036)½ = 16.2%
If the correlation (c) instead is .3, then the
combined standard deviation is:
(f2+p2+2*2*fpc)1/2 =
(152+.062+4*.15*.06*.3)1/2 = 19.2%
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2009
Portable alpha provides an opportunity to have
our cake and eat it too. But unless it’s used correctly, it can dramatically increase the volatility
of our portfolio through leveraging exposures at
the wrong time (as often occurred in 2008).
Portable alpha is a portfolio of hedge funds
overwritten with any index futures or swaps
to gain exposure to the desired asset class. The
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MPA account must retain enough cash (or near
cash) to meet marks to market on all futures,
even when the market goes into a tailspin. It
then invests remaining cash in a portfolio of
underlying hedge funds. We might think of the
MPA account as a corporation. Its assets are its
cash reserve account and the hedge funds; its liabilities are the deposits by the futures account,
on which it pays Libor interest. The difference
each month between its assets and liabilities is
its net earnings.
It is important to maintain flexibility in putting
the program together. In that way, if we encounter extraordinary times, we’re not locked into a
failing strategy. We can get liquidity in the swap
side of a portable alpha program even if we
have greater rigidity in terms of the underlying
hedge funds.
We should look at the long-term volatility
of a portable alpha strategy versus a traditional long-only strategy as a basis for deciding
whether we want to pursue a portable alpha
course. This should be viewed in the context of
the total portfolio risk and beta. We want the
flexibility to change that. We should also be
mindful of our overall leverage.
If our portfolio of hedge funds can outperform
Libor by four to five percentage points per
year, then even with the collateral and reserve,
the result is far better than a truly exceptional
active stock or bond manager who can outperform their benchmark by one to two percentage
points per year.
A portable alpha strategy generally has higher
volatility than the index fund alone—but not
much higher if the hedge fund account has a low
correlation to traditional markets.22 Correlations
that are greater than zero can rapidly increase
BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Chapter 3 – Constructing A Successful
Hedge Fund Portfolio (cont.)
“
L
TCM taught us
that we did not have
volatility in stressed markets. This is where
problems have arisen. Most hedge funds have
a correlation with the stock market of 0.5 or a
little higher. Too few investors have recognized
that fact. It is challenging to assemble a hedge
fund portfolio with a low correlation to stocks,
especially during times of extreme stress when
correlations tend to increase.
Each futures account is funded with cash equal
to the notional value of the index fund that is
accessed through futures. The futures account
must post typically 5% cash collateral with the
counterparty, and the rest can be deposited in a
master portable alpha (MPA) account.
reliable methods to
understand non-linear
risks, fat-tail risks, and
illiquidity.
”
—Andrew Lo
Is Portable Alpha Broken?
When measuring the relative success or failure of a particular asset class or strategy, the
start- and end-points matter, and they matter
greatly. One must be very careful when drawing conclusions about portable alpha after one
of the worst years in capital markets history.
Looking back on 2008—a year that saw hedge
fund indices drop more than 20% and equity
markets nearly twice as much—it is difficult to
argue that portable alpha has been a successful strategy. But you’d also be hard pressed to
demonstrate that portable alpha is irreparably
broken. For this argument to be true, the losses
would have to be so great as to render the program worthless.
A plan sponsor with a 10% allocation to portable alpha that experienced average results of
-20% in its hedge fund portfolio in 2008 (i.e.,
-20%), could expect an alpha detraction of
some 170 basis points (bps) at the total plan
level. Under normal circumstances, assuming
hedge fund returns of Treasuries plus 5%, the
same program might produce 45 bps of alpha
per year. This means the alpha lost in one
year could be recovered in less than four normal years—within the time frame that might
be considered “acceptable” (i.e., the average
CIO’s tenure is seldom shorter).
PORTFOLIO CONSTRUCTION
Most institutional investors are aware of the
variety of betas that even a diversified hedge
fund portfolio may contain. Separating causal
from spurious factors is no easy task. Results
are all that matter. Nevertheless, broad-based
deleveraging, along with a massive reduction
in liquidity, caused correlations across asset
classes to rise dramatically. This cannot last
forever; at some point fundamental factors
must certainly overwhelm technical pressures.
We believe hedge fund beta, under normal
conditions, is sufficiently small to afford the
construction of a successful absolute return
portfolio. The rest of the portfolio can be
adjusted to offset the additional beta resulting
from the portable alpha.
I
“
t is challenging to
assemble a hedge fund
portfolio with a low
correlation to stocks,
especially during times
In sum, we believe reduced competition and
reduced leverage have set the stage for attractive returns in hedge funds for years to come.
While there are several industry shortcomings
that need to be addressed, the investment thesis for employing a portable alpha program
remains largely intact.
of extreme stress when
correlations tend to
increase.
”
Source: A large U.S. pension fund
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41
Chapter 3 – Constructing A Successful
Hedge Fund Portfolio (cont.)
Terminating A Hedge Fund
Account
W
“
e should not
fire a manager solely for
performance reasons.
42
”
2009
Not all hedge fund investments work out as
planned. Sometimes we must terminate a hedge
fund. Some general principles include:
• We are fiduciaries. We must be
objective in protecting the interests of
our institution, including terminating
managers we may like personally.
• It’s really all about the people.
Sometimes we are wrong about a
manager’s skill or diligence. Sometimes
a key person leaves the firm. Either is a
cause for reconsidering the allocation.
• A manager’s non-performance-related
growth in assets under management is
often a strong signal that the manager
values its revenues more than our
returns.
• We should not fire a manager solely
for performance reasons. Investing in
alternatives is all about longer-term
value-creation processes. The timing of
returns can be uncertain. Performance
is a clue to what is really going on.
It should only be a cause for action
if further investigation reveals that it
is symptomatic of larger problems.
These may include too many assets,
style drift beyond competency, chasing
returns, or a negative performance
impacting the survivability of the
hedge fund.
by finding shorts; buying near value “floors;” or
by activist strategies in bankruptcies.
Most hedge fund managers are highly dependent on liquid and “rational” markets, where
arbitrage relationships mean-revert and fundamental value is eventually rewarded. The
correlation of hedge funds to equity or credit
markets may not be great most of the time.
However, correlations can zoom toward one
during market dislocations, as happened in
2008. In fact, many hedge funds exhibit a beta
of greater than one during crises due to their
leveraged balance sheets.
There are four practical implications of this:
1. Diversification. Balance and diversification
by risk, both on a manager and on a
strategy basis, provide a key management
tool. An advantage of a hedge fund over a
separate account invested like a hedge fund
is that we can’t lose more than our investment in the hedge fund but we could with a
separate account.
Dealing With Risk
Liquidity matters. Banks and prime brokers
provide the financing for leveraged programs. Hedge funds tend to trade in less liquid, private, and longer-duration situations.
And they may provide greater liquidity to
investors than their underlying trading program. In such cases, they borrow short-term
while investing longer term since it often
takes time for individual investment strategies to pay off.
Volatility of returns is the standard statistical
measure of risk. The lack of symmetry of some
hedge fund returns renders this measure less
useful. Quality hedge funds focus on downside protection and positive compounding.
Downside protection can be done in a number
of ways: hedging market dislocations; implicitly
This becomes problematic during market
dislocations, when investors seek liquidity and lenders withdraw financing. Prime
brokers and banks will move aggressively to
protect their capital, withdrawing funding
lines at the least opportune time. This can
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2.
BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Chapter 3 – Constructing A Successful
Hedge Fund Portfolio (cont.)
to benchmark hedge funds is missing the
point. For equity long/short managers
who generally run net long, there is some
logic in looking at indices as guideposts.
For unconstrained hedge fund managers,
T-bills plus a spread to reflect the riskiness
of the investment is a good place to start.
force fire sales by the hedge fund. If a fund
doesn’t have term financing in place and
long notice periods for changes in margin
haircuts, it can blow up.
Redemptions from the fund also tend to
increase during an economic downturn.
Fund of funds may need to redeem because
of their redemptions. Past market crises
(1994, 1998, and 2002) saw outflows from
the hedge funds overall. In the second half
of 2008, $800 billion left the industry.
More is likely to follow. Raising gates and
suspending redemptions may offer temporary relief to the manager trying to quell a
run on the bank.
Ironically, the worse the liquidity terms
provided by a hedge fund, the better for
investors in times of crisis. If few can
redeem, managers do not have to destroy
their investments by liquidating at inopportune moments.
A number of hedge funds have added side
pockets for illiquid investments. These
investments only apply to investors at the
time an investment is made. They cannot
be redeemed until the investment is eventually cashed out. This is fair to all investors,
especially if a fund allows investors the
option to participate in all side pockets or
in none. Side pockets can be problematic
for investors who require liquidity.
3.
Tracking-error and other benchmark-centric terms aren’t relevant to hedge funds.
Hedge fund managers should be original
thinkers. They are not likely to be integrated into large, established money management firms. They will have exposures
dramatically different from indices. Trying
PORTFOLIO CONSTRUCTION
4.
Consider hedging out tail risk. Some hedge
funds have similar volatility and correlation characteristics to those of fixedincome but with higher returns except,
of course, in times of market distress.
Spending some return to hedge against
this possibility pays off when the markets
suffer large losses. This gives us both the
wherewithal to avoid fire-sale liquidations
of our portfolio and the firepower by
which to buy up those of others.
I
“
ronically, the
worse the liquidity terms
provided by a hedge fund, the
better for investors in times
of crisis.
”
How much insurance? Spend too little and
the protection will not be enough. If we
spend too much, the drag on performance
will be too great. The answer of how much
to spend will depend largely on how risky
a program we are running. Some investors
think it’s between 1% and 3% a year.
The simplest protection involves buying
deep out-of-the-money puts on equity or
credit indexes. Both have defined downside—the premium you spend. The composition and management is more art than
science. Two reasons:
• Index puts on the S&P 500 during
1998 wouldn’t have helped. Large
capitalization equity indices suffered
relatively few losses compared with
small cap equities, credit instruments,
and most relative value spreads. The
pricing of options varies as they
approach expiration and also depends
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43
Chapter 3 – Constructing A Successful
Hedge Fund Portfolio (cont.)
T
“
he best time to
buy insurance is when it
is cheap. Yet this may be
when it seems to be needed
the least.
”
on how far away the strike price is
from the current market price.
• Insurance costs vary based on
demand. When the need to insure is
high, normally indicated by elevated
volatility, the price rises. The best time
to buy insurance is when it is cheap.
Yet this may be when it seems to be
needed the least.
and time-consuming to maintain. Overpaying
for a hedge is as poor an idea as overpaying
for an investment. When the cost is reasonable,
however, a hedging strategy may allow investors
to take advantage of an opportunity that otherwise would be excessively risky. In the best of all
worlds, an investment that has valuable hedging
properties may also be an attractive investment
on its own merits.”23
There is one caveat. When the exposure and the
hedging instrument are not perfectly matched,
there’s likely to be enormous basis risk in this
program. The program will never exactly hedge
the specific risks in the portfolio. Nor will it
hedge all market scenarios. It is not always
smart to hedge. Hedges can be expensive to buy
As investors, we need to be honest about our
ability to execute hedges. If we are a large,
sophisticated organization that can devote the
necessary resources to the task, we could run the
program in-house. Otherwise, we should either
refrain from hedging or hire others to do so.
“
I
t is particularly important to be on the lookout
for first-rate managers in under-represented styles.
”
23
Seth Klarman, Margin of Safety,
(1991). P. 214.
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BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Chapter 4 – Constructing a Successful
Private Capital Portfolio
“There are many painters, but few Picassos.”
—Verne Sedlacek
Private capital is investing in non-publicly
traded companies or by taking public companies private or making private investments
in public companies. Some divide the industry into venture capital and other “private
equity.”
Venture capital finances the creation and development of new businesses. The focus of private
equity is usually on the transformation of existing enterprises, although sometimes the term is
used to encompass venture capital as well.
Private equity usually applies to equity-related
capital that finances changes in private and
unquoted companies. It is also associated with
buyouts and mezzanine capital (subordinated
debt and preferred equity). The term sometimes
includes private equity investments in public
companies (growth equity), direct loans, and
distressed investments in companies headed for
or already in bankruptcy.
Investment Strategies
1.
Buyout firms acquire a company or business unit from shareholders, often with the
use of financial leverage. Investment targets
tend to be companies with mature cash
flows and operations strapped with growth
impediments that hinder performance.
These companies tend to favor private over
public capital because they can raise capital
more quickly and with minimum publicity. Another benefit may include lower
investment banking fees plus the buyer’s
ability to add value by providing financial
expertise, management recruitment, and
operational experience.
PORTFOLIO CONSTRUCTION
2.
3.
Small buyout firms tend to invest regionally. Mid-sized firms tend to invest nationally. Large firms invest in global markets.
Leveraged buyout funds often finance 70%
or more of a target’s price tag with debt.
This takes advantage of a tax deduction
on the debt’s interest. Some buyout firms
may rely chiefly on financial engineering to
achieve their returns. This influences their
purchase price during an auction, their exit
strategy, and their portfolio companies’
path to profitability. It also adds to the risk
of the venture.
Mezzanine capital includes investments in
debt or hybrid securities subordinated to a
company’s capital structure except senior
to its equity. The structure and coupon
of the investment are crucial given its
subordination. This capital can be raised
quickly without filing requirements and
is employed when other sources are either
unavailable or more complex with regard
to disclosure and placement.
Venture capital makes equity investments
in startup and less mature companies with
small or no current earnings but with the
potential for growth in revenue. Not all
companies have revenue plans at the time of
funding. Private capital helps launch products, fund early development, or expand an
incipient business. Venture capital comes
in stages. In contrast to buyout strategies,
venture firms rely on their experience in
selecting breakthrough technologies and
entrepreneurial teams.
V
“
enture firms rely on
their experience in selecting
breakthrough technologies
and entrepreneurial teams.
”
Venture capital firms consist of a small
group of experienced people. They are
experts at evaluating and identifying the
most promising enterprises. They take
seats on the board, make important industry introductions, offer business strategy
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45
Chapter 4 – Constructing a Successful
Private Capital Portfolio (cont.)
4.
L
“
BO funds know
how to manufacture
returns. As financial
5.
engineers they understand
the impact of time and fees
on IRR and the need to
invest rapidly.
”
—Ed Mathias
advice, and aid in capital-raising strategies.
They can add significant value to young
companies.
Buy-ins include private equity investments in
more mature companies looking to expand,
restructure, enter new markets, or finance
a major acquisition. These companies typically want to raise money but retain control
of their business. Venture growth equity is
often the first institutional capital in a profitable or near-profitable maturing business.
Distressed investors buy equity or debt securities in companies that are heading toward
or are already in bankruptcy. They often
nurse them through the bankruptcy process
and help to control the outcome. Many
traditional hedge funds include distressed
securities in their portfolios. Beginning in
2008, many of the large LBO firms shifted
strategies to allocate significant sums to
buying bank loans at distressed prices.
Another private capital opportunity is a secondary investment in an existing partnership.
Capital invested in private equity is normally
locked up for a decade or more. Sometimes, an
institution or a private investor has an immediate need for cash. Other investors are willing to
buy its limited partner interests, often at a discount to net asset value. The purchase includes
the obligation of undrawn commitments. Many
secondary interests trade for premiums when
the general partner is a top-tier player with
limited capacity for new investments or investors. Discounts occur when the general partner’s
track record is mediocre. Discounts also occur
if the portfolio companies are under water, the
fund has large unfunded obligations, or the market environment is bleak.
24
A graph that depicts a low internal rate
of return (IRR) in the early stages of a
fund, due to startup costs, and then an
increased IRR due to profitability.
46
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Structural Characteristics Of
Private Capital
Private capital investments are normally structured as limited partnerships with management
and performance fees charged to investors. The
management fee for such partnerships is charged
on committed capital rather than the amount
actually called and invested. In some cases (but
seldom in venture capital) a “preferred” return
hurdle must be cleared (around 8%) before paying the partnership’s general partners.
The major differentiations between illiquid and
marketable alternatives are the commitment’s
duration, the investment’s cash-flow profile, and
the lack of meaningful quarterly market values.
Many private capital partnerships require investors to lock up their capital for 10 to 12 years.
The manager often has the authority to call for
an extension of two years or more. Some private
capital partnerships are for shorter terms. Once
capital is committed, it is called over a period
of three to six years at uncertain rates. Many
managers call all their committed capital well
before six years.
The pattern of cash flows after the commitment
depends on the opportunities the manager finds
and the time needed to realize exits on investments. Exits depend on the pace of operational
improvement and the public equity market
environment. Early on, as capital is called, the
partnership’s cash flows and its portfolio’s
cash burn rates are both negative. Ideally, the
partnership’s returns increase, recover the initial
capital, and generate return well in excess of this
amount. This negative return pattern during the
investment time frame yields what is referred to
as a “J curve.”24
Investors often overlook the fact that as time
advances, private capital programs evolve from
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BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Chapter 4 – Constructing a Successful
Private Capital Portfolio (cont.)
a use of cash to a source of cash. Distributions
sometimes occur before all the commitment
has been drawn. Therefore, the investor’s peak
allocation to private capital may only reach 65
cents for every $1 of commitment to private
capital. This means that an investor would
actually have to commit substantially more
than $1 of exposure desired.25 While it takes a
number of years to get invested initially, it takes
continued commitments to stay fully allocated
to the asset class. The converse is also true. We
can de-allocate to private capital by simply not
re-upping at the same rate.
Managers face a declining revenue stream as
their companies succeed with an initial public
offering (IPO) or acquisition. They raise new
funds once the previous one is nearly fully invested.
With the current partnership still in progress,
investors must base their investment decision on
past partnerships and the manager’s reputation.
The good news is that the top-tier firms have
shown persistence in staying on top.
What Have Private Capital
Programs Returned?
Creating a successful private capital program
fueled the difference between the good and
the great endowments over the past 30 years.
Private capital programs require long-term
investments that offer advantages over public
markets. Public companies tend to focus either
on the short-term goal of meeting Wall Street
expectations or investing in the long-term value
of an enterprise. Companies backed by private
equity know they must create a compelling position in five years in order to sell. This results in
a more focused effort to increase a company’s
long-term efficiency and effectiveness.
Historically, many private equity investors have
been well compensated for locking up their
PORTFOLIO CONSTRUCTION
capital for 10 or more years. There’s been a
significant change in the industry’s market capitalization focus. Early on it was investments in
mostly small- and mid-capitalization situations
(RJR Nabisco was the notable exception). In
the past few years until the middle of 2007,
it’s been enormous funds investing in megacapitalization companies.
T
“
he name of
the game is vintage year
diversification.
”
—Janet Hickey
Investors in first quartile venture capital firms
have been even more generously compensated despite enormous fluctuations in annual
returns. As in private equity, the quality of the
lead general partners or the reputation of the
venture capital firm has an overwhelming effect
on investors’ results.
Unpredictable changes in the investment environment mean that the vintage year matters
enormously. Venture capital funds raised during the early 1990s yielded some enormous
returns. Since 1999, with the notable exception of Google, it produced some spectacularly
large losses. This is an argument for “vintage
year diversification”—investing across multiple
years. We can never be certain how investments
made today will perform 10 years out.
Private capital has historically valued investments by holding them at cost until a realization or impairment occurs. This technique has
resulted in smoothing returns and understating
volatility, which also affects correlations and
beta measures. The estimates on correlation
for private capital range from zero through
0.78. Those advocating a lower beta measure
note that private capital investments’ underlying
return generation does not theoretically depend
on the performance of equity markets. But these
correlations are understated because of the slowresponding valuations of private investments.
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25
FLAG Capital Management, 2008.
“The Commitment Conundrum,” Insights
(January). Using the example of their fund
of funds, which call capital at the rate of
one-third of the commitment per year for
the first three years and return 1.75x over
the lifetime of the partnership.
2009
47
Chapter 4 – Constructing a Successful
Private Capital Portfolio (cont.)
In the case of venture capital, the formation and
nurturing of companies, as well as the underlying innovation cycle, are somewhat independent
of equity markets. However, the outcome is
highly dependent on the size of the IPO market.
In reality, exit multiples for any private investment matter a great deal. Given this and the
uncertainty over interim valuations, it’s best to
err on the side of safety and assume a higher
beta. Higher return assumptions usually favor
private capital over public equity investments in
most optimizations. However, this may not be
borne out by median returns of venture capital
or other private capital.
I
“
n reality, private
capital is more of an
‘access class’ than an
asset class.
”
The recent adoption of FAS 157 in the United
States requires the use of fair market value estimates of an investment on financial statements.
This means that partnership returns will now
exhibit more mark-to-market volatility.
Best Practices In Private Capital
Portfolio Construction
Selecting Investments
The difference in performance between top and
average partnerships is enormous in private
capital. Fortunately, selecting the best general
partners might seem easier than other alternative investments because of the persistent top
performance of the best firms. Since this is widely known, getting allocations to these general
partners is neither egalitarian nor democratic,
especially for venture capital. In reality, private
capital is more of an “access class” than an asset
class. Selecting quality private capital investments involves six main steps:
• Sourcing managers,
• Performing due diligence,
• Negotiating partnership terms,
• Funding commitments,
• Ongoing monitoring of the investments,
and
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• Rebalancing allocations.
There are many ways to find good fund managers. The best unbiased advice comes from references from institutions investing in the space or
from an institution’s own investment managers.
Trade publications, databases, marketers, and
facilitating service providers (investment banks,
etc.) also provide some understanding of the
universe and the tiering of quality.
Since access to top firms may be difficult, there
is some merit in using a fund of funds for initial
allocations to the class. Funds that buy partnerships on the secondary market may also offer
the ability to invest in top-tier partnerships if
they include some of those partnerships in their
portfolio. There are also occasional spin-offs
from top-tier firms where talented managers
start their own businesses. Being a good investor and actively participating in the industry can
help open doors.
We should perform the same due diligence and
exacting attention required on any potentially
large transaction. Gain confidence in a manager’s investment process, understand its culture
and business practices, verify its operational
procedures, and check references. The 10-plus
year lock-up on capital and the private nature of
the investment requires extra due diligence and
work. The allocation hurdle should be higher
than for managers of liquid assets.
We should include an examination of and
interviews with current and past portfolio companies in our due diligence—understand the
track record in detail, not just the headline IRR
numbers:
• What kinds of companies have
been bought and sold, and at what
multiples?
BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Chapter 4 – Constructing a Successful
Private Capital Portfolio (cont.)
• Which companies have not been sold
and why?
• What happened to underlying
companies’ fundamentals (revenues,
cash flow, and margins)?, and
• Is the track record built on one or
two home runs that might be luck, or
on a record that is longer and more
consistent?
3.
Every investment is about people. This is an
important issue to understand, because the key
people make the difference.
PORTFOLIO CONSTRUCTION
A
“
n important side
letter is a most-favorednation provision, which
We should know whether the manager brings
value by actively improving the companies or
earns value mainly by buying at the right price.
It is essential to examine investment terms to
ensure fair treatment. Important partnership
terms spelled out in the offering documents,
such as fees, liquidity, and scope of the mandate
are usually non-negotiable. This is especially
true at a top-tier firm. An investor’s size or
reputation might lead to slightly lower fees in
exchange for larger commitments or name association. The following four items are points to
include in the limited partnership agreement:
1. Key Person: This clause provides for a vote
on continuation of the partnership if the
key principal(s) running the fund leave the
firm. Since the quality of decision makers
heavily drives returns and the investment
can last a decade or more, it is vital to
ensure that we continue to get the decisionmaking expertise of the key principals we
expected when we initially invested.
2. Expenses: In addition to the management
and performance fees, there are other fees
charged to the partnership (legal, administrative, etc.). The LP always gets the first
dollar of distributions. The key point is
what fees and expenses are charged to the
partnership before distributions.
Clawback: Initial successes by a partnership may not be matched in later years,
and the general partner may receive more
performance fees in the early years than
are subsequently warranted. In that case, a
clawback provides that the general partner
must pay those excess fees back to the limited partners.
4.
It is best, of course, if there is no need for
a clawback. Terms preferably should state
that the general partner doesn’t share in any
profits until the LP receives its capital for
the entire fund. A clawback never makes
the investor entirely whole. It doesn’t provide for the time value of money, especially
at the fund’s rate of return.
Commitment: A corollary to the key man
clause, this concerns the amount of attention a key principal gives to the fund
rather than his or her mere presence in the
partnership. Non-compete clauses for the
principal may be included. This means that
there can be no bait and switch of a talented
senior partner for less proven members of
their team.
says we will be offered
any better terms that are
subsequently offered to any
other investor.
”
We can help ensure that issues of particular
importance are addressed by negotiating a side
letter with the fund. An important side letter is
a most-favored-nation provision, which says we
will be offered any better terms that are subsequently offered to any other investor.
In these negotiations, investors seek to strike
a balance between fulfilling fiduciary obligations and dealing with highly sought-after general partners who may look askance at overly
aggressive investors and their lawyers. The aim
is for a genuine partnership between investors
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49
Chapter 4 – Constructing a Successful
Private Capital Portfolio (cont.)
and managers. Commitments by the general
partner to put the investors’ interests first and
backed by legal protections allow the relationship to deepen with time.
D
“
Once the commitment is made, capital calls
will occur over three to six years. Many investors fund the investments by liquidating public
equity positions.
iversify across
managers and vintage
years, with a preference for
weighting better managers
more heavily.
”
Monitoring follows the same as with other
investments but with the need also to follow
results of the portfolio companies. Visiting
some companies while performing other investment duties can often be fruitful. This is especially true if we are looking at new markets or
industries where ground-level knowledge can
be invaluable.
Combining, Sizing, And
Rebalancing Positions
When building portfolios of private capital
investments on a stand-alone basis, there are
three best practices to keep in mind:
1.
2.
3.
Collect as much top quality private partnerships’ capital as possible (but only top quality). Access and capacity are often limited.
Get in when you can.
Diversify across managers and vintage
years, with a preference for weighting better managers more heavily.
Develop a liquidity management plan.
Top Quality. Build the portfolio from the bottom up, allocating only as much as we can
obtain in top quality managers. Filling buckets
is a sure-fire road to disappointing results if
the performance of median managers (let alone
bottom quartile ones) is flat. Should some additional capacity in a top-quality fund become
available and we find ourselves over-allocated
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to private capital, it is better to make the investment rather than take a pass. We can hedge the
position with a suitable proxy, such as shorts on
small cap growth or technology-health care indices. Some believe allocations to 25 or 30 venture
funds (across managers and vintages) are considered necessary for good results. Others think
it’s too many.
Diversify. Diversify managers, strategies, and
vintage years with an eye toward consistently
equal-weighting committed capital by vintage
year at the asset class level. It is almost impossible to make any robust prediction for any
single fund over a 10-year period. Since top
managers maintain a competitive advantage, it’s
best to allocate across the higher quality firms
and participate in each subsequent fundraising. Allocations received will never be exactly
as desired, but keeping commitments as close
as possible to the target is a good discipline.
Committing capital to private equity and venture managers over multiple vintages is important for proper diversification. Also, staying a
member in good standing in “the club” helps
to get an allocation the next time the manager
raises a new fund.
Time to Hedge. Accept the uncertainty inherent in all investing, especially in private capital.
The long period of operational improvement
and entrepreneurial growth of portfolio companies may lead us to view them as largely
uncorrelated with equity markets. But as an
exit looms closer, the dependence on equity
market performance increasingly influences
the ultimate realization. This is especially true
for venture capital, whose realizations tend to
cluster as the IPO window opens and disappear as it closes. Investors who hedged their
venture capital portfolio in 1999 still profited
from the businesses floated without incurring
BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Chapter 4 – Constructing a Successful
Private Capital Portfolio (cont.)
the risk of the market downturn starting the
following year.
Liquidity Management. Develop a liquidity
management plan for private capital investments. Assuming that we make commitments
over time to a variety of managers across various sectors, the cash-flow demands for capital
calls seem steady. During market downturns,
capital calls for private equity may increase
as managers seek to invest in temporarily
depressed or mispriced assets. This is a challenge for investors. Their liquidity portion has
likely declined at the same time as capital is
being called. Liquidating investments at the
bottom is a way to destroy value.
The need to over-commit to the asset class in
order to achieve target allocations, plus “reupping” to maintain access, sets up a potentially nasty situation. Investors would be wise to
understand the potential timing of when existing
commitments may be called and when managers
may ask for new commitments. It helps to talk
with our managers regularly and put contingencies in place, such as lines of credit with banks
or brokers. Fortunately, after four or five years,
cash begins flowing back from private capital
allocations, although the timing is unlikely to
match capital calls closely. Cash management
for alternatives is considerably complicated.
Investors need to dedicate time and effort in
order to manage this effort properly.
D
“
evelop a
liquidity management
plan. During market
downturns, capital calls for
private equity may increase
as managers seek to invest
in temporarily depressed or
mispriced assets.
PORTFOLIO CONSTRUCTION
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”
51
Chapter 5 – Constructing A Successful Real
Estate Portfolio
“Three things are to be looked to in a building:
that it stands on the right site; that it be securely
founded; that it be successfully executed.”
—Johann Wolfgang von Goethe
R
“
Real estate, if you include all land investments,
is the largest asset class. It is also one of the
best inflation hedges and has only a modest correlation with stocks and bonds. This makes it a
useful diversifier.
eal estate assets
tend to appreciate during
times of high inflation,
Property investments form the bulk of the “real
assets” category, which also includes energy
and timber. High inflation historically coincides
with periods of poor performance for stocks,
bonds, and cash on an inflation-adjusted basis.
Real assets tend to appreciate during times of
high inflation, as replacement costs and rents
rise. These effects have generally more than
offset the rise in cap rates that parallels the rise
in interest rates.
as replacement costs and
rents rise.
52
”
2009
Real estate investments fall into three general
categories:
1. Core Real Estate. These are income-producing assets, usually intended for long holding
periods, which use light leverage targeting
high single-digit returns.
2. Value-Added Real Estate. These are usually
short-term investments with moderate leverage where the manager strives to add value
to a property in one of multiple ways, then
sells it to earn low to mid-teen returns.
3. Opportunity Funds. These typically involve
high leverage with a return target of high
teens and sometimes more.
Property investments can further be segmented
by size and geography. In almost all cases, a
portion of rental income must be reserved for
the cost of providing maintenance and periodic
refurbishing. Though most structures are longlived, changes in usage and “fashion” can lead
to eventual obsolescence.
Institutional real estate investments are more
narrowly defined as land and structures in
urban or semi-urban areas for commercial or
industrial purposes. These include office buildings, apartment houses, hotels, retail malls, and
industrial warehouses. Raw land for development may also be included. In all cases, tenants
agree to pay rent in exchange for use of the
property over a set period. In contrast to other
alternative investments, rental income provides
a much more sizable portion of returns.
Real estate investments exist in more structures
and forms than the dominant limited partnership structure of other illiquid alternatives. Some
of the largest investors make direct investments
in real estate, building the necessary property
management and development skills in-house.
Many investors use operating company wrappers, gaining talented managers through private
equity investments in their development and
operating companies.
Commonly viewed advantages of private real
estate are that its volatility is lower than that
of common stocks, and it has a low correlation
with the stock market. Part of these advantages
result from the hybrid bond-and-equity nature
of real estate, and part from the smoothing
effect that necessarily stems from valuations by
appraisal.
The advent of the real estate investment trust
(REIT) structure in 1960 permitted real estate
(initially through mortgage pools) to be listed
publicly. The Tax Reform Act of 1986 allowed
direct property ownership and operation by
REITs. This led to a wave of initial public offerings in the 1990s, which grew into a $300 billion market capitalization industry.
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BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Chapter 5 – Constructing A Successful Real
Estate Portfolio (cont.)
In the mid-1980s, institutional investors convinced real estate operators to adopt the private
equity partnership and fee structures. The typical preferred return26 was often 8%. Kodak and
other corporate pension funds were doing this
before 1985.
This forms a large part of the return to investors. From 1980 through 2007, as measured
by the National Conference of Real Estate
Investment Fiduciaries Index (NCREIF), private
real estate returned 11.5% per annum (8.4%
real). The rental income stream (“coupon”)
divided by the property’s sale value is called the
capitalization (cap) rate, a measure of the yield.
Most institutional investors view cap rate as a
yardstick for the value and attractiveness of a
particular property.
Real estate has always been a highly cyclical
business. There are periods of leverage-financed
overbuilding that lead to low cap rates and
eventual losses in an economic downturn. Real
estate’s value is based on appraisal pricing.
In the case of NCREIF, appraisals are done
quarterly. Appraisals tend to lag actual market
pricing, which results in a smoothing of returns.
The 3.75% standard deviation of returns indicated by NCREIF data substantially understates
the true volatility of property investments.
Best Practices in Real Estate
Portfolio Construction
Selecting Investments
In sourcing real estate operators, institutional
investors have a range of options. There are
REITs as well as private real estate, either
owned directly or though private real estate
funds.
Managers value each property quarterly (as
reported to NCREIF) and have an outside
auditor do an appraisal usually once a year.
Investment analysts estimate the value of REIT
properties on a macro basis because they
have no independent appraiser on a propertyby-property basis. Investor interest in REITs
fluctuates. In good times, REITs trade at a
premium to their net asset value (NAV)27. In
a market downturn, investors tend to avoid
the instrument and the class. This allows for a
discount to open up. The companies may often
take advantage of this fluctuation by issuing
more shares at the premium and purchasing
properties for their portfolios. They sell properties and buy back shares when shares trade at a
discount to NAV.
3
“
99 Park Avenue is not
very attractive when you look
at it as a 1955 office tower.
But it is attractive when its
long-term leases are viewed
as a 15-year bond with an
8 percent yield.
”
—Sam Zell
Return variations between average and top private real estate managers lie somewhere between
hedge funds and private equity. The difference
is skill in acquiring, managing, and disposing of
real properties. Operational competence and an
innate sense of market timing are keys to success. We should invest the time to get to know
the players, build a reputation as a committed
investor, and collect quality teams.
26
This entitles investors to receive a return
on their money before any other portion is
shared with the general partner.
27
The total market capitalization is greater
than the net asset value.
PORTFOLIO CONSTRUCTION
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53
Chapter 5 – Constructing A Successful Real
Estate Portfolio (cont.)
L
“
isten to our
managers. They have the
best sense of when the party
is over and when it’s time
to move on.
”
There are two functions in running a fund—the
entrepreneurial job of managing the fund, and
the day-to-day job of managing the property
(property management). Many fund managers
hire independent property managers. Some prefer to do both functions. Real estate programs
can be successful with the functions of fund
management and property management either
combined or separated. Due to potential conflicts of interest, the manager should have no
other source of income from the program, either
directly or indirectly than overall fund management and performance fees—no separate property management, development, or investment
banking fees. And we should also ensure that the
manager is meaningfully invested alongside us as
a limited partner.
Combining, Sizing, And
Rebalancing Positions
2009
We should diversify by property type (office,
retail, commercial, residential, leisure) and by
geography. Some investors believe they need
only three to five partnerships with quality
operators to obtain the desired exposure. Others
believe a fairly sizable number of real estate
managers may be required, depending on the
portfolio’s size and the operators chosen. Some
top-tier real estate managers who concentrate in
a particular area may be worth including.
In building solid stand-alone real estate portfolios, there are four best practices:
1. Be a contrarian when appropriate (also plan
for the worst case);
2. Collect quality operators opportunistically;
3. Diversify, but not excessively; and
4. Listen to our managers.
Real estate is one of the few alternative investments where it may pay to build a core in-house
capability. Even investment partnerships in core
real estate must sell their properties at the end
of a fund’s term regardless of whether or not
investors would prefer to continue holding the
specific property.
The ability to time the investment correctly is
the largest determinant of success in real estate.
Getting the theme and the timing right is essential. Arriving late to the party can be worse than
missing it entirely. Just ask the Japanese investors who bought marquee U.S. properties in the
late 1980s only to sell them at steep losses a few
years later.
Because of the cyclical nature of the asset class,
it is vital that we establish an excellent partnership relationship and talk with the managers we
hire. They have the best sense of when the party
is over and when it’s time to move on.
Real assets have a structural reason to be in
investors’ portfolios. But sizing of positions
should vary opportunistically as opposed to the
more static allocations given to hedge funds and
private equity.
54
Finding quality managers is critical. Quality
managers are better able to spot opportunities,
do complicated transactions, execute the plan,
operate the buildings profitably, and time the
exit well. Should prospects for the overall real
estate market appear poor, we can hedge by
shorting some public REITs and real estate company stocks against the allocation.
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Value-Added Real Estate
Value-added and opportunity funds are more
aggressive approaches. A manager buys a property, adds material value in a timely manner,
and promptly sells the property to someone who
wants good core real estate.
BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Chapter 5 – Constructing A Successful Real
Estate Portfolio (cont.)
The epitome of adding value is development.
This means converting raw land into a wellleased building or investing in sewers, roads,
and other infrastructure to bring a much higher
price from a developer. Development can earn
the highest returns or, if unsuccessful, be the
source of large losses.
Here are some of the ways real estate managers
can add value:
• Buy a well-located Class C office
building, rehabilitate it, and re-lease it
as a Class B office building;
• Buy an office building with a poor
leasing structure, perhaps leased in such
a way that leaves pockets of unattractive
rental space. Then re-lease the building
to earn a higher aggregate rent;
• Buy a tired-looking shopping center
and refurbish it. Through the new
owner’s national affiliations, give it
more nationwide leasing clout;
• Buy an industrial park of warehouses
and convert them to light industrial,
inexpensive back offices, or special
retail; or
• Buy a poorly managed hotel and install
new, more aggressive management.
(Hotels are classed as real estate, but
they are more like operating businesses
than passive real estate.)
PORTFOLIO CONSTRUCTION
Leverage
Leverage, borrowing up to 60% of book value,
is one way that value-added real estate managers try to add return. As it adds volatility, leverage can increase the expected return and lower
the correlation of the portfolio with stocks and
bonds. But leverage is a double-edged sword.
If the program is not successful, losses can be
dramatic including loss of the property.
T
“
he epitome of
adding value is development.
Leverage may make eminent sense for some
real estate programs. But we should evaluate
the appropriateness of our real estate manager
borrowing at the prime rate plus X% while our
bond manager is lending at prime minus X%.
Development can earn
Another key consideration of leverage is unrelated business income tax (UBIT). UBIT was
established to keep tax-exempt investors from
enjoying an advantage over taxable investors.
The tax has applied, for example, to earnings
resulting from acquisition indebtedness (leverage at the time of purchase). The rules do,
however, allow for the tax-free use of leverage
if done in certain ways. Therefore we will need
to hire a competent tax adviser if we are a U.S.
tax-exempt investor.
large losses.
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the highest returns or, if
unsuccessful, be the source of
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Chapter 6 – Constructing A Successful
Natural Resources Portfolio
“Though wisdom cannot be gotten for gold, even
less can be gotten without it.”
—Samuel Butler
N
“
atural resource
returns are poorly or
negatively correlated to
stocks, bonds, and real
estate.
”
—Clark Binkley
56
2009
Natural resources include any hard assets
extracted from above or below the ground. The
sub-groupings are energy, timber, metals, and
agriculture. Institutional investors traditionally
allocate to energy and timber. Private investors
and fund of funds allocate to all. There are four
main types of investments:
1. Commodity Indices. A variety of commodity indices attempt to represent the
performance of an asset class. Given the
complications of trading and storing physical commodities, most investors trade the
futures contracts instead. The indices measure an investment in the futures of various
commodities. They are weighted by liquidity, annual production, or a combination of
both. Because all futures contracts have a
termination date, traders roll them forward
using a common methodology. A wide variety of products provides index exposure. A
total return swap is the simplest and lowest
cost alternative. More complicated optionsbased and non-standard indices are a bit
more costly. Liquidity can be daily.
2. Commodity Traders. A subset of hedge
fund managers trades futures on physical commodities in a variety of fashions.
The most common are discretionary commodity managers who examine underlying
supply and demand fundamentals. Based
on supply/demand imbalances, they trade
long or short, both on an outright and
spread basis. Trend followers use technical
signals to capture larger directional moves.
Relative value managers focus on spreads
between related or proximate instruments.
Some managers focus on the stocks and
bonds of individual global commodity
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3.
4.
companies. Liquidity is most often monthly
or quarterly. Those who trade futures systematically offer better liquidity than those
who trade the physical commodity or structure private investments.
Private Energy Partnerships. There are enormous sums involved in finding, developing,
and exploiting energy. Given this fact, the
energy industry offers investors a number of
choices. The 1980s and 1990s saw a secular
decline in oil prices and under-investment in
energy. Coupled with the growing demands
from China, India, and Brazil, a potentially
rich opportunity exists for investors. Most
institutional investment is done through
private equity partnerships in oil, gas, and
other energy sectors. Private equity specialists in energy are few in number. But
they offer expertise in evaluating the entire
food chain, spotting bottlenecks, improving
operations, and forecasting evolving opportunities. Some oil and gas partnerships
are structured around individual exploration and production opportunities. These
are organized mainly for private investors.
Partnerships covering a broader range of
opportunities are organized primarily for
institutional investors. In both cases, investor commitments last a decade or longer.
Timber. Institutional investors began investing in timber in the late 1980s. Timberland
investments are normally limited partnerships, which acquire, operate, and sell timber farms. Initially, they focused on North
American forests, but increasingly they are
also invested in the Southern Hemisphere.
Timber management organizations offer
access through limited partnerships lasting
10 to 15 years. A recent development has
been the establishment of timber REITs
(real estate investment trusts).
BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Chapter 6 – Constructing A Successful
Natural Resources Portfolio (cont.)
What Should A Natural
Resource Program Produce?
Natural resources can be valuable additions
to an overall portfolio because of their low
correlation with stocks and other assets. With
strong management, they can provide attractive returns and provide useful hedges against
inflation. From the 1960s through recent years,
natural resource indices outperformed inflation
by roughly 5%.
Natural resources can be traded in a passive
or active fashion. Passive programs normally
involve commodity futures indices (not spot
or cash), often with a heavy weighting toward
various petroleum futures. Historically, returns
follow large bull and bear market cycles.
Commodity markets offer many more inefficiencies for active traders. Their returns are a
blend of market betas (commodity indices) and
skill. As a result, returns are moderately correlated with raw materials indices but, especially
on a risk-adjusted basis, can be greater than
pure, passive investments.
The better energy partnerships blend private
equity techniques to produce historically high
returns. As a result, investors often ladder their
private energy investments by vintage year,
much like venture capital.
Timberlands were one of the past century’s
best investments, outperforming equities, partly
because of rising land prices in the Pacific
Northwest. Investments today are mainly in
timber farms, as old growth can produce less
and less of the world’s timber needs. The price
of timber has had strong cycles but with a
modestly increasing trend over the long term.
Well-managed timber farms can provide low
double-digit returns.
PORTFOLIO CONSTRUCTION
Given the different return generation mechanisms, natural resource sub-categories bear
little statistical relationship to each other. This
allows investors to build attractive risk/reward
portfolios. These real assets offer additional
protection against rising (and unanticipated)
inflation that normally impairs equities and
fixed income.
N
“
atural resources
can provide attractive
What direction will commodity prices follow?
Bullish cases come in two flavors:
• Malthusian 28
supply
shortages
brought on by emerging markets’
rapid economic growth out-stripping
the planet’s physical production
capacity (as in the case of agricultural
commodities) or
• Outright production declines due to
depletion of easily available supplies
of nonrenewable commodities, such as
Hubbert’s Peak29 theories on oil.
returns and provide hedges
against inflation.
”
Supply can increase considerably in responses
to higher prices, thereby moderating those price
increases. Volatility may increase as more money
and attention are devoted to these markets.
There is little evidence of the compression of
embedded risk premium because index-related
activity remains small relative to the total market size. Many commodity markets moved from
backwardation to contango30 a few years ago.
This leads some to think that the risk premium
disappeared. But backwardation is not synonymous with the presence of a risk premium.
Instead, it can be an extra source of return to
investors in commodity futures. Should the
amount of capital deployed in indexed and
active commodity programs become major
ongoing allocations like stocks, bonds, and
cash, the risk premium could decline.
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28
Thomas Malthus (1766-1834). “The
power of the population is indefinitely
greater than the power in the earth to produce subsistence for man.”
29
Marion King Hubbert (1893-1989).
Petroleum production begins at zero,
reaches a peak, and then declines for any
individual oil field, region, or globally.
30
Contango is a condition in which the
delivery prices for futures exceed spot
prices due to the cost of storage as well
as insurance of the underlying commodity. The opposite is backwardation. This
is when near future spot prices are higher
than later deliveries. This usually occurs
because of excess of demand over supply.
2009
57
Chapter 6 – Constructing A Successful
Natural Resources Portfolio (cont.)
T
“
here will always
be demand for the most
There will always be demand for the most highly
skilled managers of commodity investments.
Many less skilled traders will be disappointing.
For energy partnerships, the search for crude oil
and technological advances should offer ample
opportunities to identify winners. But the area
remains volatile. The price of oil tends to drive
short-term results, and even in the course of a
long-term uptrend, short- and even mediumterm downtrends can easily occur.
The various indices have dramatically different
allocations to individual commodities, and they
therefore have different risk/return profiles. The
S&P/GSCI weights by annual production, which
can be measured in various ways. The Dow
Jones-AIG index weights primarily by the liquidity of the individual contracts. The Rogers Index
weights by a combination of consumption and
liquidity. In contrast, the Reuters-CRB index
weights each underlying commodity equally.
Timber is a relatively small asset class, and especially in the U.S., the flood of institutional capital over the past 15 years dramatically increased
prices and compressed yields. Opportunities
in the Southern Hemisphere, where trees grow
twice as fast as in the United States, remain
promising for well-managed timber partnerships, subject to cyclical ups and downs in
timber prices. Jeremy Grantham in his book,
All the World’s a Bubble, made the case that,
because of its growth, low volatility, hedge for
inflation, and lack of correlation, timber could
conceivably warrant a risk premium lower than
common stocks. But that has not occurred yet.
Index weightings of gold and oil vary widely.
Gold’s weighting ranges from 1.6% in the
S&P/GSCI to 7.4% in the Dow Jones-AIG.
Reuters-CRB and Rogers split the difference at
5.9% and 3%, respectively. Crude oil sees even
more dramatic variations in weightings—from
41% of the S&P/GSCI and 35% of the Rogers
International, to 13% of the Dow Jones-AIG
and 6% of the Reuters-CRB.
highly skilled managers of
commodity investments.
”
Passive Investing
Given these differences, it is not surprising that
index investors can have substantially worse
or better outcomes than others, even over the
medium term. From 2000 to 2007, energy was
the best performing commodity group, with
oil and gas up 12% to 13% per year and uranium up 19% a year. Not surprisingly, S&P/
GSCI’s energy-heavy weighting outperformed
all the other indices by a wide margin. Such a
tilt also brings much greater volatility to the
index. Its beta is similarly dominated by the
energy complex. The late 2008 energy sell-off
disproportionately hit the S&P/GSCI with much
greater losses.
The first allocation to commodities is often
made through passive commodity index products. This can bring many of the benefits of
commodities to the overall portfolio in a simple
cash efficient and liquid allocation. The first
decision is the choice of an index.
Second, how an index “rolls” to the next
contract can impact returns. Rules generally
stipulate that the investment will be in the nearmonth contract and that the roll from one to
another happens on a specific day at the close of
Best Practices In Natural
Resource Portfolio
Construction
Investors have a myriad of opportunities.
Selecting the right type of exposure or the best
active managers is crucial to the success of an
investment program.
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2009
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BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Chapter 6 – Constructing A Successful
Natural Resources Portfolio (cont.)
trading. Liquidity may be concentrated in various months, however, and the roll may instead
skip ahead to the next liquid month.
Third, investors must choose their exposure.
There are three components to the return of a
commodity futures program:
• The change in the spot prices of the
underlying commodities,
• The return from rolling expiring
contracts to near months, and
• The return on the collateral posted to
satisfy margin requirements.
Investors can usually choose between spot
indices, excess return (spot plus roll), and total
return (excess plus futures collateral). Most
indices assume a fully collateralized futures
program. This means the full notional exposure
is backed by cash instruments rather than only
the required margin (around 5% of notional).
We must also consider what instrument best
suits our needs. Often exposure is obtained
through simple total return swaps with a bank
or investment bank. There are also futures on
the indices as well as variations on exchangetraded funds (ETFs). The Chicago Mercantile
Exchange offers futures on the S&P/GSCI while
the Chicago Board of Trade offers them on the
DJ-AIG. Due to regulatory issues, ETFs cannot
hold commodity futures. Instead, companies
have floated exchange-traded notes that use
swaps to provide the same exposure within regulatory guidelines. Any complications beyond
simple exposures materially add to the cost of
obtaining exposure. If the goal is for passive
exposure, it is difficult to justify the additional
complications or costs.
PORTFOLIO CONSTRUCTION
Discretionary Commodity
Managers
Discretionary commodity managers follow a
different approach than commodity trading
advisers (CTAs). Most use deep analysis of fundamental supply and demand trends to generate
positions through futures contracts (and occasionally options or equities). A minority may
also trade physical commodities. While large
moves are not necessary to produce returns,
large moves are necessary in individual commodities or in the spreads between them. Since
these appear more often during commodity
bull markets, good returns indirectly depend on
upward trending markets.
Commodity equities managers are basically
common stock hedge managers focusing largely
on commodity-related companies. They are
distinct from other long/short equity managers
because their opportunity set is a function of
commodity price moves. They produce superior
returns when they correctly anticipate these
moves and correctly forecast how these moves
will play through their companies’ balance
sheets, and how management and other investors will react.
T
“
he scarcest
resource isn’t oil, gas, coal, or
uranium—it’s management
talent. It’s best to find a
proven and experienced
operating team and keep
investing with them.
”
Commodity relative value managers are much
smaller in number and tend to trade spread
relationships between commodity futures or
between the physical and futures markets. An
example is calendar spreads where a manager
will go long December versus short June natural gas to play the slowdown in demand normally seen in the summer.
Key considerations in hiring discretionary managers of commodities include:
1. Consider the quality and talent of the
fund’s principals. Do they have deep experience, an understanding of supply and
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59
Chapter 6 – Constructing A Successful
Natural Resources Portfolio (cont.)
2.
S
“
ize is normally the
enemy of performance.
”
3.
4.
demand in the relevant commodities, and
the ability to trade equities and futures (and
possibly provide physical delivery as well)?
More importantly, understand how discretionary commodity managers manage risk
and collateral. Futures have the advantage
of liquidity. It’s possible to trade out of
money-losing positions at a low price when
viewed in terms of trading costs. Futures
also have linear payoffs so losses are theoretically unlimited. Stop losses are often
used to handle this. Risk management is
critical in this strategy. An independent risk
manager who liquidates positions by hitting
a stop is better than relying on the trader
who initiated the position.
Size is normally the enemy of performance.
Do the managers’ business and operational
infrastructure support their type and quantity of trading? Are they adequate for the
size of assets they trade? A large manager
who trades infrequently may need less operations support than a smaller one who turns
over the portfolio every few days.
Does the manager possess integrity and
put the needs of the client first? Does the
manager offer a fee arrangement that is fair
compensation for value-added and rewards
investors for the risks?
Discretionary management of commodities is different from “managed futures,” as described in
Chapter 3 under hedge funds. Both are managed
by commodity trading advisers (CTAs). The difference is that the CTAs who invest in “managed
futures” trade not only physical commodities
but also financial commodities, such as interest
rate futures and foreign exchange, and they rely
mainly on technical (price) information rather
than fundamental supply/demand information.
Their returns are little correlated with pricing
cycles of physical commodities.
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Private Energy
Private energy includes managers specializing in
the energy sector, including direct investments
in oil and gas producing properties. Selecting
managers involves the same six steps as selecting
quality private capital:
• Sourcing managers,
• Performing due diligence,
• Negotiating partnership terms,
• Funding commitments,
• Ongoing monitoring of the investments,
and
• The rebalancing or exiting of the
investment.
The energy sector adds a further twist—a specific skill set for exploration and production. It
is a highly complex business. Ph.D.-level geologists and computer scientists search for wells;
the wells are worked by roughnecks who are
brought to deep-water platforms by specialist
helicopter pilots. Investors should hire managers
with operating skills in all of these areas plus
financial and deal-making skills. The scarcest
resource isn’t oil, gas, coal, or uranium—it’s
management talent. It’s best to find a proven and
experienced operating team and keep investing
with them.
As part of our due diligence, we need an
in-depth understanding of the geology and
economics of the properties, the management
team’s operating abilities, legal structures and
cash controls, and the backgrounds of the professionals involved.
Timberlands
Selecting timberland investments seems fairly
straightforward. The timber fund’s manager
buys a forest and then begins to harvest and
re-plant, ideally leading to a forest with relatively equal amounts of each age tree. Most
BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Chapter 6 – Constructing A Successful
Natural Resources Portfolio (cont.)
institutional investors use partnerships, which
typically have a three-year investment period.
Most greenfield plantations (newly planted forests) take 25 to 30 years to grow. The lifecycle
of a partnership is generally 10 or more years,
so the opportune timing of the sale of the forest
is important.
The quality of the investment manager and the
staff is crucial—people skilled in evaluating
timberlands, forestry management, and negotiating transactions. The initial price paid for a
forest is a key determinant of ultimate return.
But operational expertise can also make a material difference during the planting, thinning,
trimming, and selling to squeeze the maximum
dollar value out of every acre of forest.
Most timber investors participate through partnerships with multiple investors. Harvard and
several other large institutions are the exception. Harvard has employed six foresters and
prefers to own 100% of a property if the
opportunity is good. That way, investors can
hold onto forests if they choose rather than
being in a partnership that sells them at a mandated partnership end date.
Combining, Sizing, And
Rebalancing Positions
When it comes to building portfolios within
the four sub-categories, we should consider the
following:
• For commodity indices, the index
providers decide the weightings. We
must decide which index and how to
obtain and fund exposures.
• For discretionary commodity traders,
the principle of equal weighting of risk
would be a starting point. Directional,
relative value, and multi-strategy
managers do not share the same risk
PORTFOLIO CONSTRUCTION
levels. Margin-to-equity is a common
measure of risk for commodity futures.
Simple equal-dollar weighting will
produce highly skewed portfolios from
a risk perspective.
• Seasoned private energy managers
stress the importance of having a macro
view regarding attractive themes.
These forces provide a “wind at your
back” as managers choose among
resources, services, equipment, and
energy alternatives. Equal weighting
of these kinds of energy investments
might be theoretically optimal, but
opportunistic investing should take
precedence. Over the duration of a
typical partnership the waxing and
waning of relative attractiveness
means that the partnership may end up
equal weighted. An equal risk weight
as a default, with some tilt toward
attractive opportunities or particularly
talented teams, is probably best.
• Timberland investors should strive for
geographic diversification, including
several locations in the Southern
Hemisphere, as well as in a range of
wood types. And again, because of
the cyclical nature of timber pricing, it
helps to diversify timber partnerships
by vintage years.
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T
“
he various natural
resource investments are
attractive because of their
potential returns and their
low correlation with the
common stock market and
also with each other.
2009
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61
Chapter 7 – Good Governance: The Crucial
Element
“Important principles may and must be
inflexible.”
—Abraham Lincoln
What Is Governance?
T
“
o be successful,
committee members must
become generalists and
be open to growth and
differing perspectives.
”
Financial decision makers for institutional
investors such as pensions and endowments are
fiduciaries and are held to very high standards
by law. The chief investment officer (CIO)
and support staff may devise a well-structured
portfolio. However, it won’t mean a thing if the
investment committee doesn’t understand the
underlying rationale. This is necessary for policies to stand the test of time, especially times of
market turbulence.
An investment committee makes the final decisions but typically devotes relatively few hours
per year to the fund. The committee must have
a competent staff (or consultant). One of the
staff’s foremost responsibilities is the continuing
education of committee members. This is especially true in developing areas of asset allocation, liquidity, leverage, and conflicts of interest.
Lower value decisions, such as implementation,
can and should be delegated to professional staff
devoted day-to-day to making those decisions.
Why It Matters
Much value can be created or lost at the
governance level, depending on the depth of
understanding of the investment committee.
The committee may consist of outside investment professionals. This is often the case of
endowment committees at large universities.
Committees may also be composed of intelligent, responsible individuals who are not
investment experts. However, with continuing
education about best practices and investment
strategies, they can gain an adequate depth of
understanding.
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Committee members who are investment professionals often contribute valuable experience and
contacts to the committees and the staff. If their
experience only focuses on particular investment
areas, they may be less comfortable considering recommendations about other investment
avenues. To be successful, committee members
must become generalists and be open to growth
and differing perspectives. They must also keep
an open mind to new or different ideas.
One of the structural advantages endowments
(and some foundations) have is their boards.
Members are often large donors or prominent
alumni who have likely attained a measure of
success. They have broad experiences, developed
networks, and a deep and emotional investment
in the institution. In contrast, American corporate pension plan investment committees are
more often composed of executives from within
the sponsoring company. Public sector plans’
boards include political appointees, with considerable conflicts of interest built in, incentives
to minimize risk-taking, and limited expertise in
many of the strategies pursued.
Conflicts can arise if the plan sponsor or a committee member has a special relationship with
an investment firm. It is appropriate and often
helpful for a fiduciary to ask the CIO to meet
with certain investment managers known to
the committee member. But it’s not appropriate
for a fiduciary to pressure the CIO to alter the
criteria for hiring a manager or otherwise to
give preferential consideration. Furthermore, a
committee member should recuse herself in all
matters concerning investments in her fund.
BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Chapter 7 – Good Governance: The Crucial
Element (cont.)
Functions Of The Investment
Committee
The committee’s foremost responsibility is
approving the fund’s investment objectives.
Those objectives should be developed in the
context of the needs and financial circumstances
of the particular institution, not simply policies
that are easy to measure performance against.
Must the institution rely only on the current
amount of assets presently in the portfolio? Can
additional contributions reasonably be raised?
How much does the fund sponsor rely on the
annual income it receives from the fund?
In any case, the CIO should lead the committee,
providing continuing education as a first priority and a cohesive approach as the second. The
CIO and staff can’t be going in one direction
and the investment committee another.
The investment committee must first adopt a
written operating policy. This policy addresses
committee membership, meeting structure and
attendance, and committee communications.
The committee’s written operating policies
should specify which actions are in the sole discretion of the CIO and which actions must first
be approved by the committee.
The next step is to adopt a written statement
of investment policies. These policies should
include one or more benchmark portfolios that
will serve as a metric to evaluate multi-year
portfolio returns. The committee then must
decide whom to hire and retain as investment
managers or delegate that responsibility—a
substantial responsibility—to the CIO and staff.
Since the committee meets for only a relatively
few hours each year, it must rely on its CIO and
staff (or a consultant) to do the research and
make recommendations.
PORTFOLIO CONSTRUCTION
What is the difference between competent and incompetent boards? Competent
boards have a preponderance of people of
character who are comfortable doing their
organizational thinking in multi-year time
frames. These people understand ambiguity and uncertainty, and are still prepared to go ahead and make the required
judgments and decisions. They know what
they don’t know. They are prepared to hire
a competent CIO and delegate management and operational authority, and are
prepared to support a compensation philosophy that ties reward to results.
—Keith P. Ambachtsheer and D. Don Ezra,
Pension Fund Excellence, John Wiley &
Sons, Inc., 1998, p. 90.
T
“
he CIO needs to
be a steward of the institution
and refrain from playing
the performance horse race.
Being average is actually a
skill.
”
—André Perold
Committee members must recognize their reliance on the staff. Their greatest responsibility
is to choose the staff and/or consultant. The
committee should expect to approve most of
the recommendations made by the people they
select. If they lose confidence in their staff or
consultants, they will need to select new ones in
whom they can place their confidence.
The Staff/Committee
Relationship
The staff must be the experts and the ones
who do the work. But they should always
remember that the fiduciary committee has
the obligation of establishing objectives and
policies. The committee makes or delegates
the investment decisions and shoulders the
ultimate responsibility.
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Chapter 7 – Good Governance: The Crucial
Element (cont.)
T
“
he staff’s primary
responsibility is to provide
continuing perspective and
education to the committee
members.
”
The staff’s primary responsibility is to provide
continuing perspective and education to the
committee members. In cases where there are
few, if any, committee members who already
possess a broad grasp of best practices, it is up
to the senior staff members to teach the committee members. Education—including the setting
of realistic expectations for return and volatility—should be done on a continuing basis. The
staff should relate each decision opportunity to
the fund’s investment policies.
The CIO and staff may come upon investment
opportunities that are highly attractive but off
the well-trodden path of institutional investors.
These require much greater due diligence and
more careful explanation to committees. But
these less conventional opportunities, if they
pass this test, can add valuable diversification to
a fund’s overall portfolio.
The ultimate test should not be, “What are our
peers doing?” Rather it should be, “What is
best for our particular fund?” and “How are we
doing against our benchmarks and needs?” To
the extent we are concerned about our peers, we
should monitor the most successful investors in
similar situations whose sponsors have approximately the same resources.
Committees need to understand that there are
years when their fund, if broadly diversified
according to best practices, will underperform
more traditionally invested funds. But committee members must learn to evaluate such relative
performance over longer intervals. For the overall portfolio, qualitative benchmarks should be
evaluated over multi-year intervals; quantitative
benchmarks over much longer periods.
31
The Greenwich Roundtable’s symposium
presentation on “Contemporary Perspectives
in Investment Policy,” Nov. 15, 2007.
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Committee Meetings
The committee should set the number of
required meeting dates a year in advance to
allow members to plan their calendars accordingly. Committee members should make every
effort to attend all meetings—if not in person,
then by conference call.
If an urgent matter arises that can’t wait for
the next scheduled meeting, a special meeting
should be called. If a matter is simple and routine, the staff can avoid a special meeting by
circulating to committee members a “consent
to action,” which, when signed by a majority of
the committee, authorizes action.
In any case, relative to recommendations, the
staff should send committee members full presentation materials several days before each
meeting. By reviewing these materials in
advance, members will be prepared to ask better questions at the meeting. The danger is that
committee members may decide how they will
vote prior to the meeting. Advanced preparation should lead to questions, not preconceived
decisions.
Evaluating Performance
Some investment policy statements include the
goal of matching or beating market benchmarks and/or some perceived peer group. This
can be dangerous. Charley Ellis notes that
outperforming markets and the “better-rate-ofreturn-than-the-other-folks” goals for investing
have gotten way too much time and attention
and are leading people away from focusing on
what really matters.31
How do we evaluate the performance of our
portfolio? The Policy Portfolio has historically
formed a “passive” benchmark against which
the outcomes of the investment process can be
BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Chapter 7 – Good Governance: The Crucial
Element (cont.)
measured. Comparing the return with that of
our benchmark Policy Portfolio32 is only one
part of the process.
We should also compare the actual results to
those of our “allocation benchmark,” which
is the compound difference between our actual
return and the quarterly return on our individual managers weighted by our actual allocations at the beginning of each quarter. Then the
difference between the Policy benchmark and
the allocation benchmark is the value added (or
subtracted) by our deviations from the allocations of our Policy Portfolio.
These metrics are most helpful with the liquid
portions of our portfolio. Illiquid positions,
with their non-market-tested quarterly valuations, only muddy what we can learn from
these metrics.
Such value added, of course, is history. Our
focus should be on continuing to source and
invest in order to modify our portfolio to
strengthen future returns. There are two parts
to every result: skill and luck. Focusing on
results, except over very long periods (such as
five years), emphasizes luck.
Meeting Topics
One meeting a year should be designated for an
in-depth review of the prior year’s performance.
This should include a performance analysis of
the fund and of each manager in the context of
various market averages and established benchmarks. Quarterly full-blown performance presentations are a waste of time for the committee
and the staff. Time is better devoted to activities
more likely to benefit the bottom line.
Presentations should cover only the salient
points. They should not overwhelm the committee with more information than it can
absorb. Staff members should have a rich depth
of additional information and background so
they can answer—knowledgeably and briefly—
any question that might arise.
rowds get diverse
Candor is perhaps the number one criterion.
The staff must gain and retain the committee’s
complete trust. The staff must be forthright
about negative news or negative aspects about
a particular manager.
information. Committees get
Meeting The Managers
express unique views. They
Investment managers should be brought before
the committee when they serve an important
educational purpose. This would include helping the committee understand new asset classes
or new ways of managing a portfolio. It may
include existing managers of the sponsor’s
fund, ones under consideration, or world-class
independent investment professionals.
It is sometimes customary for committees to
meet recommended managers. At times they
meet “finalist” managers one after the other.
But in 20 to 30 minutes, a committee’s interview can be little more than superficial. The
committee can, at best, determine a manager’s
ability to articulate. Eloquence, however, has
a low correlation with investment capability.
Committee members cannot bring the staff’s
perspective of having met with hundreds of
managers. Nor can the committee do the kind
of homework the staff should have done. The
committee’s decision ultimately comes down to
whether the committee has confidence in the
staff and believes the staff has done its homework adequately.
Staff presentations should concisely cover the
key questions the committee ought to ask.
PORTFOLIO CONSTRUCTION
C
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homogeneous information,
and people are reluctant to
suffer from dysfunctional
politeness.
”
—Arnie Wood
32
Calculating the return of our benchmark Policy Portfolio is straightforward for
standard asset classes – we simply use the
passive index return for each asset class.
Benchmarks for hedge funds, however, are
more difficult. Hedge funds, by definition,
don’t have a passive index. Instead, we can
use relevant hedge fund strategy indexes.
Or, alternatively, some investors simply use
T-bills or Libor plus the minimum incremental return they would expect in order to
invest in a hedge fund.
2009
65
Chapter 7 – Good Governance: The Crucial
Element (cont.)
Bringing managers to the committee for performance reports is rarely helpful. Their reports
generally cover their outlook for the economy,
their interpretation of the account’s recent performance, and recent transactions. The reports
are superficial and myopic. A cogent, concise
report by the staff can do a better job of surfacing issues and placing things in a helpful
perspective for making decisions.
D
“
avid Swensen’s
client is Yale University.
His portfolio was
Working With New Committee
Members
underwater for several
years, and he managed to
keep his job. The real hero
The staff should make a special effort to bring
a newly appointed committee member up to
speed. The staff should supply the new member
with key documents. These include the fund’s
objectives and policies and its target asset allocation, together with their underlying rationale.
was the Yale Investment
Committee. They were
the buffer between the
administration, the alumni,
Understanding the why of everything is critical. One-on-one sessions with the CIO may be
needed to supplement key documents. A brief
meeting with the fund’s legal counsel to outline
the committee member’s legal responsibilities
may also be helpful.
What Can Smaller Funds Do
For Staffing?
If the fund sponsor is too small to afford hiring
a first-rate staff, it can either hire a consultant
that performs some specific staff duties or outsource the entire staff function to a firm that
takes it all on.
Sponsors of funds that can’t afford a first-rate
consultant should recruit one or two investment
committee members who are broad-gauged
investment professionals and are familiar with
best practices. That member (or members)
should be appointed to an investment subcommittee or working group, which would be
responsible for making recommendations to the
full committee.
Even larger fund sponsors sometimes find an
investment subcommittee useful. It can work
most closely with the fund’s consultant, review
the consultant’s recommendations in advance,
and help prepare the agenda for each meeting.
and the appearance of
imprudence.
”
—Peter Bernstein
O
“
ne of the single biggest mistakes we make is taking irrelevant information and
building it into a generality. Then everyone (on the committee) confirms that generality.
This is confirmation bias.
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”
—Arnie Wood
BEST PRACTICES
IN
ALTERNATIVE INVESTING:
We, As CIO and Staff,
Ask of Committee Members:
1.
2.
3.
Keep an open mind and be willing to consider new investments and investment managers. Ask
hard questions, lots of them. Make us prove to you that a new kind of investment or a new
manager, net of fees, will add to the portfolio’s expected return and either maintain or reduce
the committee’s expected portfolio risk.
Be willing to consider illiquid investments, provided our portfolio will remain liquid enough
to meet all of our contingent payout obligations.
Relative to our policy allocation to illiquid asset classes, allow us the years and flexibility to
build a diversified portfolio on an opportunistic basis.
4.
Be willing to consider out-of-favor strategies or opportunistic investments that cause deviations
in asset allocation if we provide a convincingly strong case.
5.
For a pension fund, be willing to consider creative ways to hedge the plan’s liabilities.
6.
Understand that performance relative to the committee’s policy benchmarks is more important
than performance relative to peers. This is especially true in the short- to medium-time frame
with market-valued investments.
7.
Review written recommendations in advance of a meeting. Do so in order to develop hard
questions, not make up your minds in advance. Ask difficult but fair questions to raise the bar
for both the staff and the committee.
8.
Expect the staff to give full consideration to an outstanding manager or investment
opportunity that a committee member might suggest, especially if the committee member can
provide a useful contact. However, do not expect that the staff will necessarily recommend
the opportunity.
9.
Don’t insist on meeting all our recommended investment managers. The committee will not
have time to meet all managers of an adequately diversified portfolio. Understand that in
a half-hour meeting with an investment manager, committee members will only be able to
evaluate the manager’s articulateness, not investment prowess.
I
“
nvesting is a never-
ending acquired skill. Staff
and the committee will grow
with experience.
”
10. Investing is a never-ending acquired skill. Staff and the committee will grow with
experience.
PORTFOLIO CONSTRUCTION
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67
We, As Committee Members, Ask Of The CIO
And Staff:
R
“
elate each
1.
Help us establish a viable policy benchmark for our portfolio. Report on a routine basis portfolio performance relative to that benchmark, especially on portions that can be market-valued
quarterly. How much of the difference from the benchmark is due to deviations from policy
allocations, and how much to managers’ performance relative to their respective benchmarks?
2.
Relate each individual recommendation to the organization’s investment policy.
3.
In recommending a new investment manager, help us understand the predictive value of the
manager’s track record, including its relevance to the current environment.
4.
For any recommendation, help us understand its expected impact on our portfolio under a
worst-case scenario.
5.
Be prepared to explain why you are equipped to make sound judgments about new kinds of
investments.
6.
Pursue continuous improvement. Seek new managers who you believe will perform materially
better than an existing manager. Recommend a change even if the existing manager has done
a good job.
7.
Be prepared to research any new manager or investment opportunity that a committee member
believes worthy of consideration.
8.
Provide reports and recommendations well in advance of each meeting. Don’t snow us with
more material than we can reasonably be expected to read. Be prepared to answer detailed
questions at the meeting.
9.
In reports, emphasize the “so what?” about manager performance.
individual recommendation
to the organization’s
investment policy.
”
10. Provide transparency. Distill information down to a summary that allows a reasonable person
to ask intelligent questions about what you’re proposing to do.
11. Provide us with an understanding of the process in which the valuation of the portfolio was
derived. Are the risks being taken consistent with the risk that was expected? What are the
metrics that you use to confirm your belief in the process?
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BEST PRACTICES
IN
ALTERNATIVE INVESTING:
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ALTERNATIVE INVESTING:
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Chapter 3 – Constructing
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n asset class should
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Chapter 4 – Constructing A
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Ennis, Richard M. and Michael D. Sebastian,
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The Journal of Private Equity, (Summer): 81-87.
BEST PRACTICES
IN
ALTERNATIVE INVESTING:
Bibliography (cont.)
FLAG Capital Management, 2008. “The
Commitment Conundrum,” Insights (January).
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“The Globalization and Outlook on Venture
Capital.”
Kaplan, Steven N. and Antoinette Schoar,
2005. “Private Equity Performance: Returns,
Persistence, and Capital Flows,” The Journal
of Finance, Vol. 60, No. 4 (August):
1791-1823.
Chapter 5 – Constructing
A Successful Real Estate
Portfolio
Citrin, Jeffrey, 2006. “The Intrinsic Value of
the Underlying Asset,” Greenwich Roundtable
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Geltner, David M., 1993. “Estimating Market
Values from Appraised Values without
Assuming an Efficient Market,” Journal of
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T
“
here is no economic
substitute for water. Demand
for water is unaffected
by inflation, recession, or
Lamm, R. McFall, Jr., and Tanya E. GhalebHarter, 2001. “Private Equity as an Asset
Class: Its Role in Investment Portfolios,” The
Journal of Private Equity, (Fall): 68-79.
Ljungqvist, Alexander and Matthew
Richardson, 2003. “The Cash Flow, Return
and Risk Characteristics of Private Equity,”
NYU Finance Working Paper, No. 03-001.
Mathias, Ed, December 2003. GR Symposium
“Private Equity: Issues & Outlook.”
Merrill Lynch Investment Managers, 2003.
Bringing Private Equity into Focus, Volume II:
Investing in Private Equity, London.
Peng, Liang, 2001. “Building a Venture Capital
Index,” Yale University ICF Working Paper,
No. 00-51.
Reyes, Jesse, 2004. “Private Equity
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PORTFOLIO CONSTRUCTION
Geltner, David M. and Goetzmann, William
N., “Two Decades of Commercial Property
Returns: A Repeated-Measures RegressionBased Version of the NCREIF Index,” Journal
of Real Estate Finance and Economics, Vol.
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interest rates. When the well
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value of water.
Kukral, John, 2006. “The Race Between
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Roundtable Quarterly, Vol. 3, No. 3: 17-19.
”
—John Dickerson
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Question of Consistency,” Journal of Property
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Zell, Sam, January 2003. GR Symposium
“Real Estate: The Other Asset Class.”
Chapter 6 – Constructing
A Successful Natural
Resources Portfolio
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“Private Timberlands: Growing Demands,
Shrinking Land Base,” Journal of Forestry,
Vol. 100, No. 2: 32-37.
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“
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”
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BEST PRACTICES
IN
ALTERNATIVE INVESTING:
NOTES
PORTFOLIO CONSTRUCTION
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Education Committee
Officers
Board of Trustees
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Federal Street Partners
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Executive Director
Edgar W. Barksdale
Federal Street Partners
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Lumina Foundation for Education
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UBS Alternative and
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Drake Capital Advisors, LLC
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Editor
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Emory Investment Management
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International Paper Company
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Granite Associates
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Commonfund Group
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pension fund
Alexis Palmer
Memorial Sloan-Kettering
Cancer Center
Alexander Poletsky
Greenwich Roundtable, Inc.
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Commonfund Institute
Robert Hunkeler
International Paper Company
Peter Lawrence
FLAG Capital Management
Stephen McMenamin
Indian Harbor, LLC
Ken Shewer
Kenmar Group
CONTACT US
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Endurance Specialty
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CPP Investment Board
2009
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The Greenwich Roundtable
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